Category: Articles

From Tweedy -Browne..

ASSETS BOUGHT CHEAP
BENJAMIN GRAHAM’S NET CURRENT ASSET VALUE STOCK SELECTION CRITERION
The net current asset value approach is the oldest approach to investment in groups of securities with common selection characteristics of which we are aware. Benjamin Graham developed and tested this criterion between 1930 and 1932.

The net current assets investment selection criterion calls for thepurchase of stocks which are priced at 66% or less of a company’s underlying current assets (cash,receivables and inventory) net of all liabilities and claims senior to a company’s common stock (currentliabilities, long-term debt, preferred stock, unfunded pension liabilities).

For example, if a company’scurrent assets are $100 per share and the sum of current liabilities, long-term debt, preferred stock, and unfunded pension liabilities is $40 per share, then net current assets would be $60 per share, and Grahamwould pay no more than 66% of $60, or $40, for this stock. Graham used the net current asset investmentselection technique extensively in the operations of his investment management business, Graham-Newman Corporation, through 1956.

Graham reported that the average return, over a 30-year period, ondiversified portfolios of net current asset stocks was about 20% per year.In the 1973 edition of The Intelligent Investor, Benjamin Graham commented on the technique:”It always seemed, and still seems, ridiculously simple to say that if one can acquire adiversified group of common stocks at a price less than the applicable net current assetsalone — after deducting all prior claims, and counting as zero the fixed and other assets –the results should be quite satisfactory.”

In an article in the November-December 1986 issue of Financial Analysts Journal, “Ben Graham’s Net Current Asset Values: A Performance Update,” Henry Oppenheimer, an Associate Professor of Finance atthe State University of New York at Binghamton, examined the investment results of stocks selling at orbelow 66% of net current asset value during the 13-year period from December 31, 1970 throughDecember 31, 1983.The study assumed that all stocks meeting the investment criterion were purchased on December 31 ofeach year, held for one year, and replaced on December 31 of the subsequent year by stocks meeting the same criterion on that date.

To create the annual net current asset portfolios, Oppenheimer screened theentire Standard & Poor’s Security Owners Guide. The entire 13-year study sample size was 645 netcurrent asset selections from the New York Stock Exchange, the American Stock Exchange and the over-the-counter securities market. The minimum December 31 sample was 18 companies and the maximum December 31 sample was 89 companies.

The mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5%per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio onDecember 31, 1970 would have increased to $25,497,300 by December 31, 1983. By comparison,$1,000,000 invested in the NYSE-AMEX Index would have increased to $3,729,600 on December 31,1983.

The net current asset portfolio’s exceptional performance over the entire 13 years was notconsistent over smaller subsets of time within the 13-year period. For the three-year period, December31, 1970 through December 31, 1973, which represents 23% of the 13-year study period, the mean annualreturn from the net current asset portfolio was .6% per year as compared to 4.6% per year for the NYSE-AMEX Index.The study also examined the investment results from the net current asset companies which operated at aloss (about one-third of the entire sample of firms) as compared to the investment results of the netcurrent asset companies which operated profitably.

The firms operating at a loss had slightly higherinvestment returns than the firms with positive earnings: 31.3% per year for the unprofitable companiesversus 28.9% per year for the profitable companies.Further research by Tweedy, Browne has indicated that companies satisfying the net current assetcriterion have not only enjoyed superior common stock performance over time but also often have beenpriced at significant discounts to “real world” estimates of the specific value that stockholders wouldprobably receive in an actual sale or liquidation of the entire corporation.

Net current asset value ascribes no value to a company’s real estate and equipment, nor is any going concern value ascribed to prospectiveearning power from a company’s sales base. When liquidation value appraisals are made, the estimated”haircut” on accounts receivable and inventory is often recouped or exceeded by the estimated value of acompany’s real estate and equipment. It is not uncommon to see informed investors, such as a company’sown officers and directors or other corporations, accumulate the shares of a company priced in the stockmarket at less than 66% of net current asset value. The company itself is frequently a buyer of its own shares.

Common characteristics associated with stocks selling at less than 66% of net current asset value are lowprice/earnings ratios, low price/sales ratios and low prices in relation to “normal” earnings; i.e., what thecompany would earn if it earned the average return on equity for a given industry or the average netincome margin on sales for such industry. Current earnings are often depressed in relation to priorearnings.

The stock price has often declined significantly from prior price levels, causing a shrinkage in acompany’s market capitalization.

I can email the full report (53 pages .pdf) for those who want it. Simply email me and ask for it

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Do not read this if easily upset…

We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it’s historic doesn’t make it any more fun, of course. But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.

Virtually the only asset class I know where the fundamentals are not impaired – in fact, where they are actually improving – is commodities. Farmers cannot get a loan to buy fertilizer right now. Nobody’s going to get a loan to open a zinc or a lead mine. Meanwhile, every day the supply of commodities shrinks more and more. Nobody can invest in productive capacity, even if he wants to. You’re going to see gigantic shortages developing over the next few years. The inventories of food worldwide are already at the lowest levels they’ve been in 50 years. This may turn into the Great Depression II. But if and when we come out of this, commodities are going to lead the way, just as they did in the 1970s when everything was a disaster and commodities went through the roof.

What I’ve been buying recently is agricultural commodities. I’ve also been buying more Chinese stocks. And I’m buying stocks in Taiwan for the first time in my life. It looks as if there’s finally going to be peace in Taiwan after 60 years, and Taiwanese companies are going to benefit from the long-term growth of China.

I have covered most of my short positions in U.S. stocks, and I’m now selling long-term U.S. government bonds short. That’s the last bubble I can find in the U.S. I cannot imagine why anybody would give money to the U.S. government for 30 years for less than a 4% yield. I certainly wouldn’t. There are going to be gigantic amounts of bonds coming to the market, and inflation will be coming back.

In my view, U.S. stocks are still not attractive. Historically, you buy stocks when they’re yielding 6% and selling at eight times earnings. You sell them when they’re at 22 times earnings and yielding 2%. Right now U.S. stocks are down a lot, but they’re still very expensive by that historical valuation method. The U.S. market is yielding 3% today. For stocks to go to a 6% yield without big dividend increases, the Dow will need to go below 4000. I’m not saying it will fall that far, but it could very well happen. And if it gets that low and I’m still solvent, I hope I’m smart enough to buy a lot. The key in times like these is to stay solvent so you can load up when opportunity comes.

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

OIL, Real Estate, Triple, Rogers

– 10 reasons

– real estate

– Triple exposure

– Easy way to follow

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

May your 2009 be better than your 2008…

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Retailers, Rich folks, More retail, Jones

– 1/4 gone?

– Spending less

– What to buy then?

– Its stock is cheaper than its product

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Should resume sporadic posting over next few days

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Cramer, iPhone, Destruction, Amex

– Better off flipping a coin

– I want it cheaper

– It is effective

– More TARP abuse

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Lecture Number Ten
MR. GRAHAM: Ladies and gentlemen, this is the last of our series of lectures. I hope that you will have found it as enjoyable and stimulating to listen to them as I have found it in preparing them.

The final talk is going to be something of departure, for it will address itself to speculation — speculation in relation to security analysis.

Speculation, I imagine, is a theme almost as popular as love; but in both cases most of the comments made are rather trite and not particularly helpful. (Laughter.)

In discussing speculation in the context of this lecture it will be my effort to bring out some of the less obvious aspects of this important element in finance and in your own work.

There are three main points that I would like to make in this hour. The first is that speculative elements are of some importance in nearly all the work of the security analyst, and of considerable importance in part of his work; and that the over-all weight and significance of speculation has been growing over the past thirty years.

The second point is that there is a real difference between intelligent and unintelligent speculation, and that the methods of security analysis may often be of value in distinguishing between the two kinds of speculation.

My third point is that, despite the two foregoing statements, I believe that the present attitude of security analysts toward speculation is in the main unsound and unwholesome. The basic reason therefore is that our emphasis tends to be placed on the rewards of successful speculation rather than on our capacity to speculate successfully.

There is a great need, consequently, for a careful self-examining critique of the security analyst as speculator, and that means in turn a self-critique by the so-called typical investor, acting as speculator.

First, what do we mean by speculation? There is a chapter in our book on Security Analysis which is devoted to the distinctions between investment and speculation. I don’t wish to repeat that material beyond recalling to you our concluding definition, which reads as follows:

“An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

That is a very brief reference to speculation. We could amplify it a bit by saying that in speculative operations a successful result cannot be predicated on the processes of security analysis. That doesn’t mean that speculation can’t be successful, but it simply means you can’t be a successful speculator in individual cases merely by following our methods of security analysis.

Speculative operations are all concerned with changes in price. In some cases the emphasis is on price changes alone, and in other cases the emphasis is on changes in value which are expected to give rise to changes in price. I think that is a rather important classification of speculative operations. It is easy to give examples.

If at the beginning of 1946 a person bought U.S. Steel at around 80, chiefly because he believed that in the latter part of bull markets the steel stocks tend to have a substantial move, that would clearly be a speculative operation grounded primarily on an opinion as to price changes, and without any particular reference to value.

On the other hand, a person who bought Standard Gas and Electric, four dollars preferred, sometime in 1945, at a low price, — say at four dollars a share — because he thought the plan which provided for its extinction was likely to be changed, was speculating undoubtedly. But there his motive was related to an analysis of value — or rather to an expected change of value — which, as it happened, was realized spectacularly in the case of the Standard Gas and Electric Preferred issue.

I think it is clear to you that in a converse sense nearly all security operations which are based essentially on expected changes, whether they are of price or of value, must be regarded as speculative, and distinguished from investment.

In our chapter on speculation and investment we discussed the concept of the speculative component in a price. You remember we pointed out that a security might sell at a price which reflected in part its investment value and in part an element which should be called speculative.

The example we gave back in 1939-1940, with considerable trepidation, was that of General Electric. We intentionally picked out the highest-grade investment issue we could find to illustrate the element of speculation existing in it. Of the price of $38, which it averaged in 1939, we said the analyst might conclude that about $25 a share represented the investment component and as much as $13 a share represented the speculative component. Hence in this very high-grade issue about one-third of the average price in a more or less average market represents a speculative appraisal. That example, which showed how considerable was the speculative component in investment securities, I think is pretty typical of security value developments since World War I. I believe it justifies and explains the first point that I wish to make, namely, that speculative elements have become more and more important in the work of the analyst. I think only people who have been in Wall Street for a great many years can appreciate the change in the status of investment common stocks that took place in the last generation, and the extent to which speculative considerations have obtruded themselves in all common stocks.

When I came down to the Street in 1914, an investment issue was not regarded as speculative, and it wasn’t speculative. Its price was based primarily upon an established dividend. It fluctuated relatively little in ordinary years. And even in years of considerable market and business changes the price of investment issues did not go through very wide fluctuations. It was quite possible for the investor, if he wished, to disregard price changes completely, considering only the soundness and dependability of his dividend return, and let it go at that — perhaps every now and then subjecting his issue to a prudent scrutiny.

That fact is illustrated on the blackboard by taking the rather extreme case of the Consolidated Gas Company, now Consolidated Edison Company, during the years of the first postwar boom and depression — namely, 1919-1923. These vicissitudes really affected the company quite severely; for you will notice that its earnings suffered wide fluctuations, and got down in 1920 to only $1.40 a share for the $100 par value stock. Yet during that period it maintained its established dividend of seven dollars and its price fluctuation was comparatively small for a major market swing — that is, it covered a range of 106 down to 71.

If we go back to the years 1936-1938, which in the textbooks is now referred to as a mere “recession” that lasted for a year, we find that Consolidated Edison Company, with no changes in earnings to speak of, had extraordinarily wide changes in price. During the year 1937 alone, it declined from about 50 to 21, and the following year went down to 17. During that period it actually raised its dividend, and its earnings were very stable. (See comparative data in the following table.)

The much wider fluctuations in investment common stocks that have come about since World War I have made it practically impossible for buyers of common stocks to disregard price changes. It would be extremely unwise — and hypocritical — for anybody to buy a list of common stocks and say that he was interested only in his dividend return and cared nothing at all about price changes.

The problem is not whether price changes should be disregarded — because clearly they should not be — but rather in what way can the investor and the security analyst deal intelligently with the price changes which take place.

I would like to go back for a moment to our statement that in the case of General Electric a considerable portion of the price in 1939 reflected a speculative component. That arises from the fact that investors have been willing to pay so much for so-called quality, and so much for so-called future prospects, on the average, that they have themselves introduced serious speculative elements into common stock valuations. These elements are bound to create fluctuations in their own attitude, because quality and prospects are psychological factors. The dividend, of course, is not a psychological factor; it is more or less of a fixed datum. Matters of the former kind — I am speaking now of prospects and quality — are subject to wide changes in the psychological attitude of the people who buy and sell stocks. Thus we find that General Electric will vary over a price range almost as wide as that of any secondary stock belonging in more or less the same price class.

Going ahead from 1939 to 1946, we find that General Electric declined from 44 1/2 down to 21 1/2 and came back again to 52 in 1946, and has since declined to 33, or thereabouts. These are wide fluctuations. I think they justify my statement that a very considerable part of the price of General Electric must be regarded as speculative and perhaps temporary.

I think also you might say that the pure investment valuation of $25 for General Electric could be said to be justified by the sequel, since there were opportunities both in 1941 and 1942 to buy the stock at those levels. It is also true that the price movement of General Electric was not as favorable between 1939 and 1946 as that of other stocks, and I think that reflects the rather over-emphasized speculative element that appeared in General Electric before World War II.

Speculative components may enter into bonds and preferred stocks as well as into common stocks. But a high-grade bond, almost by definition, has practically no speculative component. In fact, if you thought it had a large speculative component, you would not buy it for investment nor would you call it high grade. But there is one important factor to be borne in mind here. A rise in interest rates may cause a substantial decline in the price of a very good bond. But even in that event a high-grade bond may be valued on its amortized basis throughout the period that it runs, and the price fluctuations could therefore be ignored by a conventional treatment of value. As most of you know, that is exactly what is done in the insurance company valuation methods which we were discussing recently. High-grade bonds are valued from year to year on an amortized basis, without reference to price fluctuations.

It may be a pleasant thing for the security analyst to get away from the speculative components that are found chiefly in common stocks and which are so troublesome, and to concentrate on the more responsive and more controllable elements in bond analysis. Wall Street, I believe, has improved very greatly its technique of bond analysis since 1929. But it is one of the ironies of life that just when you have got something really under control it is no longer as important as it used to be. I think we must all admit that bond analysis plays a very much smaller part in the work of the analyst and in the activities of the investor than it used to. The reason is perfectly obvious: The greater portion of bond investments now consist of U.S. government bonds, which do not require or lend themselves to a formal bond analysis.

While it is true that for the minor portion of corporate bonds that remain you can go through all the motions of careful bond analysis, even that is likely to be somewhat frustrating. For I am sure that a really competent bond analyst is almost certain to come up with the conclusion in nearly every case that the typical buyer would be better off with a Government bond than with a well-entrenched corporate security. The purchase of these corporate securities in the present market is a kind of pro forma affair by the large institutions who, for semi-political reasons, desire to have corporate bonds in their portfolios as well as Government bonds. The result is that the wide field of bond analysis, which used to be so important to and so rewarding to the bond investor, must now, I think, be written down pretty far in terms of practical interest.

So much, then, for my first point: That willy-nilly we security analysts find that more and more significance attaches to speculative elements in the securities that we are turning our attention to.

On the second point, which relates to the analyst’s role in distinguishing intelligent from unintelligent speculation, I would like to treat that matter chiefly by some examples. I have picked out four low-price securities, which I think would illustrate the different kinds of results which an analyst may get from dealing with primarily speculative securities. These are, on the one hand, Allegheny Corp. Common, which sold at the end of the month at five, and Graham-Paige Common, which sold at five; and, on the other hand, General Shareholdings, which sold at four, and Electric Bond and Share six dollars Preferred “Stubs”, which could be bought yesterday at the equivalent of three.

When we first look at these securities, they all seem pretty much the same — namely, four speculative issues, which they certainly are. But a deeper examination by a security analyst would reveal a quite different picture in the two pairs of cases.

In the case of General Shareholdings we have the following: This is the common stock of an investment company, which has $21.5-million of total assets, with senior claims of $12-million, and a balance of about $9.5-million for the common. The common is selling for $6,400,000 in the market. That means that in General Shareholdings you have both a market discount from the apparent present value of the stock and an opportunity to participate in a highly leveraged situation. For if you pay $6.4-million of the gross asset value; and consequently every ten per cent of increase in total asset value would mean a 30 per cent increase in the book value of the common.

Furthermore, you are practically immune from any danger of serious corporate trouble; because the greater portion of the senior securities — in fact, five-sixths of it — is represented by a preferred stock on which dividends do not have to be paid and on which there is no maturity date.

Consequently, in the General Shareholdings case, you have that typically attractive speculative combination of (a) a low-price “ticket of entry” into a fairly large situation; and (b) instead of paying more than the mathematical value of your ticket, you are paying less; and © if you assume that wide fluctuations are likely to occur in both directions over the years, you stand to gain more than you can lose from these fluctuations.

So much for General Shareholdings, viewed analytically.

By contrast, if you go to Allegheny Corporation at five, although it seems at first to be a somewhat similar situation — namely an interest in an investment company portfolio — you find the mathematical picture completely different. At the end of 1945 the company had about $85-million of assets, and against it there were $125-million claims in the form of bonds and preferred stocks, including unpaid dividends. Thus the common stock was about $40-million “under water.” Yet at five you would be paying $22-million for your right to participate in any improved value for the $85-million of assets, — after the prior claims were satisfied.

The security analyst would say that there is plenty of leverage in that situation, of course; but you are paying so much for it, and you are so far removed from an actual realizable profit, that it would be an unintelligent speculation.

The fact of the matter is you would need a 70 per cent increase in the value of the Allegheny portfolio merely to be even with the market price of the common as far as asset value coverage is concerned. In the case of General Shareholdings, if you had a 70 per cent increase in the value of its portfolio, you would have an asset value of about $15 a share for the common, as against a market price of around four.

Thus, from the analytical standpoint, while Allegheny and General Shareholdings represent approximately the same general picture, there is a very wide quantitative disparity between the two. One turns out to be an intelligent and the other an unintelligent speculation.

Passing now to Graham-Paige at five dollars, we find another type of situation. Here the public is paying about $24-million for a common stock which represents about $8-million of asset value, most of which is in Kaiser-Fraser stock. This you can buy if you want in the open market, instead of having to pay three times as much for it. The rest of the price represents an interest in $3-million of assets in the farm equipment business — which may prove profitable, as any business may be profitable. The only weakness to that is that there is no record of profitable operations here, and you are paying a great many millions of dollars merely for some possibilities. That, in turn, would be regarded as an unintelligent speculation by the security analyst.

Let us move on now to the Electric Bond and Share Stubs, which I shall describe briefly. They represent what you would have left if you had bought Electric Bond and Share Preferred at $73 yesterday and had then received $70 a share that is now to be distributed. What remains is an interest in a possible ten dollar payment, your claim to which is to be adjudicated by the SEC and the courts. That ten dollars represents the premium above par to which Electric Bond and Share Preferred would be entitled if it were called for redemption. The question to be decided is whether the call price, the par value, or some figure in between should govern in this case.

It should be obvious, I think, that that is a speculative situation. You may get ten dollars a share out of it for your three dollars, and you may get nothing at all, or you may get something in between. But it is not a speculative operation that eludes the techniques of the security analyst. He has means of examining into the merits of the case and forming an opinion based upon his skill, his experience, and the analogies which he can find in other public utility dissolutions.

If we were to assume that the Electric Bond and Share Stubs have a 50-50 chance of getting the ten dollar premium, then he would conclude that at three dollars a share they are an intelligent speculation. For the mathematics indicates that, in several such operations, you would make more than you would lose in the aggregate. These examples lead us, therefore, to what I would call a mathematical or statistical formulation of the relationship between intelligent speculation investment. The two, actually, are rather closely allied.

Intelligent speculation presupposes at least that the mathematical possibilities are not against the speculation, basing the measurement of these odds on experience and the careful weighing of relevant facts.

This would apply for example, to the purchase of common stocks at anywhere within the range of value that we find by our appraisal method. If you go back for a moment to our appraisal of American Radiator, you may recall that in our fifth lecture we went through a lot of calculations and came out with the conclusion that American Radiator was apparently worth between $15 and $18 a share. If we assume that that job was well done, we could draw these conclusions. The investment value of American Radiator is about $15; between 15 and 18 you would be embarking on what might be called an intelligent speculation, because it would be justified by your appraisal of the speculative factors in the case. If you went beyond the top range of $18 you would be going over into the field of unintelligent speculation.

If the probabilities, as measure by our mathematical test, are definitely in favor of the speculation, then we can transform these separate intelligent speculations into investment by the simple device of diversification. That, I think, is a clue to the most successful and rewarding treatment of speculation in Wall Street. The idea, in fine, is simply to get the odds on your side by processes of skillful, experienced calculation.

Going back to our Electric Bond and Share example, if we really are skillful in our evaluation of the possibilities here, and reach this conclusion of a 50-50 possibility, then we could consider Electric Bond and Share Stubs as part of an investment operation consisting of, say, ten such ventures of a diversified character. For in ten such operations you would get $50 back for an investment of $30, if you have average luck. That is, you would get ten dollars each on five of them and you would get nothing on another five, and your aggregate return would be $50.

Very little has been done in Wall Street to work out these arithmetical aspects of intelligent speculation based on favorable odds. In fact, the very language may be strange to most of you. Yet it oughtn’t to be. If we are allowed to commit some misdemeanor by making some mild comparisons between Wall Street and horse-racing, the thought might occur to some of us that the intelligent operator in Wall Street would try to follow the technique of the bookmaker rather than the technique of the man who bets on the horses. Further, if we assume that a very considerable amount of Wall Street activity must inevitably have elements of chance in it, then the sound idea would be to measure these chances as accurately as you can, and play the game in the direction of having the odds on your side.

Therefore, quite seriously, I would recommend to this group, and to any other, that the mathematical odds of speculation in various types of Wall Street operations would provide a full and perhaps a profitable field of research for students.

Let us return for a moment to Allegheny Common and Graham-Paige Common, which we characterized as unintelligent speculation from the analyst’s viewpoint. Is not this a dangerous kind of statement for us to make? Last year Graham-Paige sold as high as 16, and Allegheny as high as eight and one quarter, against the current figure of five. It must be at least conceivable that their purchase today might turn-out very well, either because (a) the abilities of Mr. Young or Mr. Fraser will create real value where none or little now exists, or (b) the stocks will have a good speculative “move,” regardless of value.

Both of these possibilities exist, and the analyst cannot afford to ignore them. Yet he may stick to his guns in characterizing both stocks as unintelligent speculations, because his experience teaches him that this type of speculation does not work out well on the average. One reason is that the people who buy this kind of stock at five are more likely to buy more at ten than to sell it. Consequently, they usually show losses in the end, even though there may have been a chance in the interim to sell out to even less intelligent buyers. Thus, in the end, the criterion of both intelligent and unintelligent speculation rests on the results of diversified experience.

When I come to my third point I am going to indicate how very different are the ordinary and customary attitudes toward speculative risk in Wall Street than those we have been discussing. But I think I ought to pause here for a minute, since I finished my second point, and see if there are some questions to be asked on this exposition.

QUESTION: By diversification, as in the case of Electric Bond and Share Stubs — you wouldn’t concentrate on ten situations similar in the way of redemption of preferred. You would want to diversify with Electric Bond and Share stocks and General Shareholdings, and some others; entirely different situations?

MR. GRAHAM: Yes, the approach is not based on the character of the operation, but only on the mathematical odds which you have been able to determine to your own satisfaction. It doesn’t make any difference what you are buying, whether a bond or a stock or in what field, if you are reasonably well satisfied that the odds are in your favor. They are all of equal attractiveness, and they all belong equally in your diversification. You make a further sound point, and that is that you are not really diversifying if you went into ten Electric Bond and Share situations — all substantially the same. You would not really be diversifying, because that is practically the same thing as buying ten shares of Electric Bond and Share instead of buying one share of each; since the same factors would apply to all of them. That point is well taken. For real diversification; you must be sure that the factors that make for success or failure differ in one case from another.

*** QUESTION: As for that 50-50 chance, why didn’t you come up with sixty-forty — in Bond and Share? I don’t see how you can be so mathematically precise.

MR. GRAHAM: Of course you are right in saying that, and I am glad you raised the point. This is not something that admits of a Euclidean demonstration. But you can reach the conclusion that the chances are considerably better than seven to three, let us say — which are the odds that are involved in your purchase — without being exactly sure whether they are 50-50 or sixty-forty. Broadly speaking, you simply say you think the chances are at least even in your favor, and you let it go at that. But that is enough for the purpose. You don’t have to be any more accurate for practical action.

(Now, bear in mind I am not trying to imply here that the figure given is necessarily my conclusion as to what the odds in the Bond and Share are. Any of you are perfectly competent to study that situation and draw a conclusion based upon what has taken place in other utility redemptions. I am only using the Stubs for purposes of illustration. I should point out that the market does not seem to be very intelligent in paying the same price for the five dollar Preferred Stubs as for the six dollar Preferred Stubs.)

The final subject that I have is the current attitude of security analysts toward speculation. It seems to me that Wall Street analysts show an extraordinary combination of sophistication and naiveté in their attitude toward speculation. They recognize, and properly so, that speculation is an important part of their environment. We all know that if we follow the speculative crowd we are going to lose money in the long run. Yet, somehow or other, we find ourselves very often doing just that. It is extraordinary how frequently security analysts and the crowd are doing the same thing. In fact, I must say I can’t remember any case in which they weren’t. (Laughter.)

It reminds me of the story you all know of the oil man who went to Heaven and asked St. Peter to let him in. St. Peter said, “Sorry, the oil men’s area here is all filled up, as you can see by looking through the gate.” The man said, “That’s too bad, but do you mind if I just say four words to them?” And St. Peter said, “Sure.” So the man shouts good and loud, “Oil discovered in hell!” Whereupon all the oil men begin trooping out of Heaven and making a beeline for the nether regions. Then St. Peter said, “That was an awfully good stunt. Now there’s plenty of room, come right in.” The oil man scratches his head and says, “I think I’ll go with the rest of the boys. There may be some truth in that rumor after all.” (Laughter.)

I think that is the way we behave, very often, in the movements of the stock market. We know from experience that we are going to end up badly, but somehow “there may be some truth in the rumor,” so we go along with the boys.

For some reason or other, all security analysts in Wall Street are supposed to have an opinion on the future of the market. Many of our best analytical brains are constantly engaged in the effort to forecast the movement of prices. I don’t want to fight our the battle over again here, as to whether their activity is sound or not. But I would like to make one observation on this subject.

The trouble with market forecasting is not that it is done by unintelligent and unskillful people. Quite to the contrary, the trouble is that it is done by so many really expert people that their efforts constantly neutralize each other, and end up almost exactly in zero.

The market already reflects, almost at every time, everything that the experts can reliably say about its future. Everything in addition which they say is therefore unreliable, and it tends to be right just about half the time. If people analyzing the market would engage in the proper kind of self-criticism, I am sure they would realize that they are chasing a will-o’-the-wisp.

Reading recently the biography of Balzac, I recalled that novel of his called, The Search for the Absolute, which some of you may have read. In it a very intelligent doctor spends all his time looking for something which would be wonderful if he found it, but which he never finds. The reward for being consistently right on the market is enormous, of course, and that is why we are all tempted. But I think you must agree with me that there is no sound basis for believing that anyone can be constantly right in forecasting the stock market. In my view it is a great logical and practical mistake for security analysts to waste their time on this pursuit.

Market forecasting, of course, is essentially the same as market “timing.” On that subject let me say that the only principle of timing that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear, or at least no longer cheap, by analysis.

That sounds like timing; but when you consider it you will see that it is not really timing at all but rather the purchase and sale of securities by the method of valuation. Essentially, it requires no opinion as to the future of the market; because if you buy securities cheap enough, your position is sound, even if the market should continue to go down. And if you sell the securities at a fairly high price you have done the smart thing, even if the market should continue to go up.

Therefore, at the conclusion of this course, I hope you will permit me to make as strong a plea as I can to you security analysts to divorce yourselves from stock market analysis. Don’t try to combine the two — security analysis and market analysis — plausible as this effort appears to many of us; because the end-product of that combination is almost certain to be contradiction and confusion.

On the other hand, I should greatly welcome an effort by security analysts to deal intelligently with speculative operations. To my mind the prerequisite here is for the quantitative approach, which is based on the calculation of the probabilities in each case, and a conclusion that the odds are strongly in favor of the operation’s success. It is not necessary that this calculation be completely dependable in each instance, and certainly not mathematically precise, but only that it be made with a fair degree of knowledge and skill. The law of averages will take care of minor errors and of the many individual disappointments which are inherent in speculation by its very definition.

It is a great mistake to believe that a speculation has been unwise if you lose money at it. That sounds like an obvious conclusion, but actually it is not true at all. A speculation is unwise only if it is made on insufficient study and by poor judgment. I recall to those of you who are bridge players the emphasis that the bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money — in the long run.

There is a beautiful little story, that I suppose most of you have heard, about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife, “I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?” And his wife replied very dourly, “If you had played it right you would have lost it.” (Laughter.)

There is a great deal of that in Wall Street, particularly in the field of speculation, when you are trying to do it by careful calculation. In some cases the thing will work out badly. But that is simply part of the game. If it was bound to work out rightly, it wouldn’t be a speculation at all, and there wouldn’t be the opportunities of profit that inhere in sound speculation. It seems to me that is axiomatic.

*** I know something of the practical problems that confront the security analyst who wants to act logically all the time, and who wants to confine himself only to that area of financial work in which he can say with confidence that his work and his conclusions are reasonably dependable. The analysts all complain to me that they can’t do that because they are expected by their customers and their employers to do something else, to give them off-the-cuff speculative judgments and market opinions. One of these days I am sure the security analysts will divide themselves completely from the market analysts.

It would be very nice to have a two-year trial period in which the market analysts would keep track of what they have accomplished through the period and security analysts would keep track of what they have accomplished. I think it would be rather easy to tell in advance who would turn in the better score. That is really the pay-off. I think that eventually the employers and the customer will come to the conclusion that it is better to let the security analysts be security analysts — which they know how to do — and not other kinds of things, particularly market analysts, which they don’t know how to do and they will never know how to do.

I would like to make some final observations, relating to a long period of time, as to what has happened to the conduct of business in Wall Street.

If you can throw your mind, as I can, as far back as 1914, you would be struck by some extraordinary differences in Wall Street then and today. In a great number of things, the improvement has been tremendous. The ethics of Wall Street are very much better. The sources of information are much greater, and the information itself is much more dependable. There have been many advances in the art of security analysis. In all those respects we are very far ahead of the past.

In one important respect we have made practically no progress at all, and that is in human nature. Regardless of all the apparatus and all the improvements in techniques, people still want to make money very fast. They still want to be on the right side of the market. And what is most important and most dangerous, we all want to get more out of Wall Street than we deserve for the work we put in.

There is one final area in which I think there has been a very definite retrogression in Wall Street thinking. That is in the distinctions between investment and speculation, which I spoke about at the beginning of this lecture. I am sure that back in 1914 the typical person had a much clearer idea of what he meant by investing his money, and what he meant by speculating with his money. He had no exaggerated ideas of what an investment operation should bring him, and nearly all the people who speculated knew approximately what kind of risks they were taking.

Link

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Lecture Number Nine
Now, we turn to the New Amsterdam Casualty case, which is interesting for a completely different set of reasons, as I pointed out in the previous lecture. Here you have a very large discount in price from break-up value, but instead of having an unprofitable company, you have one which, over the years, has shown very good results indeed. Instead of having the stockholders suffering from what might be called a certain waste of assets — in the sense of a business which is carried on for years on a relatively losing basis — you have exactly the opposite: The stockholder is suffering from an undue desire by management to gather together and retain all the assets possible and to give out as little as they decently can to the stockholders. I think the contrast in the two cases is very extraordinary, and it deserves some careful thinking on your side. For it shows that the stockholders’ interests are affected by developments and policies of a very diverse nature, and that a stockholder can suffer from failure to pay out earnings, when they are realized, nearly as much as he suffers from the failure to realize earnings.

Now, that will be vigorously denied by corporate managements, who insist that as long as the money is made and is retained in the treasury the stockholder does not possibly suffer and he can only gain. I think you gentlemen are better qualified than anyone else to be the judge of that very question. Is it true that the outside stockholder invariably benefits from the retention of earnings in the business, as distinct from the payment of a fair return on the value of his equity in the form of dividends? I believe that Wall Street experience shows clearly that the best treatment for stockholders is the payment to them of fair and reasonable dividends in relation to the company’s earnings and in relation to the true value of the security, as measured by any ordinary tests based on earning power or assets.

In my view the New Amsterdam Casualty case is a very vivid example of how security holders can suffer through failure to pay adequate dividends. This company, as I remarked two weeks ago, has been paying a one dollar dividend, which is the same amount as paid by the other two companies. Its average earnings have been very much higher. For the five years 1941-45, the earnings are shown to have averaged $4.33, after taxes, as against which their maximum dividend has been one dollar per annum.

You will recall that the North River Company during that period earned an average of $1.12, one quarter as much, and paid the same dividend of one dollar. And the American Equitable, which earned an average of nine cents in those five years, also paid one dollar. If the New Amsterdam Company had been paying a dividend commensurate with its earnings and its assets, both, there is no doubt in my mind but that the stockholders would have benefitted in two major ways: First, they would have received an adequate return on their money, which is a thing of very great moment in the case of the average stockholder, and secondly they would have enjoyed a better market price for their stock.

It turns out that we have an extraordinarily pat comparative example here in the form of another casualty company, called the U.S. Fidelity and Guaranty. This pursues an almost identical line of business, and has almost identical earnings and almost identical assets, per share, as has New Amsterdam. But it happens to pay two dollars a share in dividends instead of one dollar a share, and so it has been selling recently at about 45; whereas New Amsterdam stock has been selling at somewhere around 26 to 28.

The difference in results to the stockholder between paying a reasonable and fair dividend and paying a niggardly dividend is made as manifest as it can be by these contrasting examples.

You may ask: What is the reason advanced by the management for failure to pay a more substantial dividend, when it appears that the price of the stock and the stockholders’ dividend return both suffer so much from the present policy?

You will find, if you talk to the management on the subject, that they will give you three reasons for their dividend policy; and if you have done similar missionary work over a period of time, the arguments will sound strangely familiar to you.

The first reason they give you is conservatism — that is, it is desirable, and in the interest of the stockholders, to be as conservative as possible. It is a good thing to be conservative, of course. The real question at issue is, can a company be too conservative? Would the stockholders be better off, for example, if they received no dividend at all, rather than one dollar — which would be carrying the conservatism to its complete extreme? I believe that experience shows that conservatism of this kind can be carried to the point of seriously harming the stockholders’ interest.

The second reason that you will get from the company — and you will get it from every other company in the same position — is that theirs is a very special business and it has special hazards; and it is necessary to be much more careful in conducting this business than in conducting the average business or any other one that you might mention. In this particular case they would point out also that the results for the year 1946 have been unsatisfactory, and that the current situation is by no means good.

Since every business is a special business, it seems to me that the argument more or less answers itself. You would have to conclude that there would be no principles by which the stockholders can determine suitable treatment for themselves, if it is to be assumed that each business is so different from every other that no general principles can be applied to it.

With regard to the statement that the 1946 results have been poor, it happens that if you analyze them in the usual fashion you would find that even in a bad year like 1946 the New Amsterdam Casualty Company appeared to earn on the order of two dollars and a half a share. Therefore it could well have afforded a larger dividend than one dollar, even if you took the one-year results alone, which it is by no means the proper standard to follow. Dividend policy should be based upon average earnings in the past and upon expected average earnings in the future.

It will be pointed out that some companies have been having difficulties in the insurance business in the last two years, and for that reason it is very desirable that conservatism be followed. We all know there have been some very unprofitable insurance concerns, and some have been profitable. To say that stockholders of profitable businesses cannot get reasonable dividends because there are some unprofitable or some possibly shaky companies in the field, I would call rather irrelevant.

The third argument — and this is especially interesting, I believe, because it comes down to the essence of stockholders’ procedures and rights — is that the stockholders do not understand the problems of the business as well as the management of a company. Therefore it is little short of impertinence for the stockholders to suggest that they know better than the management what is the proper policy to follow in their interest.

Of course, the trouble with that argument is that it proves too much. It would mean that regardless of what issue was raised, the stockholders should never express themselves, and should never dare to have an opinion contrary to the management’s. I think you would all agree that the principle of stockholders’ control over managements would be completely vitiated if you assume that managements always knew what was the best thing to do and always acted in the stockholders’ interest on every point.

I want to say, with regard to the New Amsterdam Company — since in this course we have been mentioning names right along, for the sake of vividness — two things: First, I should have started by saying that my investment company has an interest in the New Amsterdam Casualty Company, and I have had a dispute with the management as to proper dividend policy. I want to say that, because you may believe that this presentation has been biased — and you are perfectly free to form that conclusion if you wish. You should be warned of the possibility of bias. My belief, of course, is that the statements made fairly represent the issues in the case.

The second point I want to make very emphatically is that the New Amsterdam Casualty Company is extremely well managed by very capable people of the highest character, and that the issue that arises here is not one of self-interest on the part of the management, or lack of ability, but solely the question of dividend policy, and its impact on the stockholders’ interest.

The solution of this problem of the stockholders’ interest in the New Amsterdam case, and many others, is not easy to predict. As I see it, after a good deal of thought, analysis and argument on the subject, you need in these cases a long process of stockholders education, so that they will come to think for themselves and act for themselves.

Whther that will ever be realized I don’t know; but I am very hopeful that people in Wall Street might play a part in giving stockholders sound and impartial guidance in regard to the holdings that they have, as well as to the securities which they might think of buying or selling.

Link

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books

Lecture Number Eight
It follows that, in dealing with undervalued securities, the analyst is likely to become greatly interested in specific corporate developments, and therefore in proper corporate policies. And from being interested in corporate policies, he may pass over into being critical of wrong policies and actively agitating to bring about correct policies — all of which he considers to be in the stockholders’ interests. For it is true that in a fairly large percentage of cases the undervaluation in the market can be removed by proper action by or in the corporation.

Consequently, by insensible stages of reasoning, the specialist in undervalued securities finds himself turning into that abomination of Wall Street known as a disgruntled stockholder.

I want to say a word about disgruntled stockholders. The trouble with stockholders, in my humble opinion, is that not enough of them are disgruntled. And one of the great troubles with Wall Street is that it cannot distinguish between a mere troublemaker or “strike-suitor” in corporation affairs and a stockholder with a legitimate complaint which deserves attention from his management and from his fellow stockholders.

*** QUESTION: In connection with investment income, isn’t it possible that the method in which that is determined might be conservative? In other words, investment income, as I understand it, would probably be income from interest, dividends, and excluding capital appreciation.

MR. GRAHAM: Yes. I am glad you raised the question, because I omitted any reference to the question of capital appreciation or depreciation in insurance company investments.

Speaking about that I would like to go back to the reasons for the popularity of insurance company shares in the 1920’s. The analyses that used to be made at that time indicated that the insurance stockholder was a very fortunate person, because he had three different and valuable sources of income. One was the insurance business, which was supposed to be a very good industry, although there was no analysis of how much it contributed in earnings in those days. It was taken for granted that it was a good business for the stockholder.

Then it was said that you got the interest on money, not only your own money, but you got interest and dividends also on a lot of money that the policyholders had left with you in the form of unearned premiums and unpaid losses, and so on. Thus, for every dollar of your own, you had a total of about two dollars working for you, drawing investment income.

The third advantage was that you had extremely capable investment managements putting your money in securities and making a lot of profits for you.

Of course they made profits for you in the 1920’s when the market was going up, and of course they lost a great deal of money in the early 1930’s when the market was going down. The same thing happened in 1937-38, when they made a lot of money up to March ‘37, then they lost a great deal in the ensuing decline.

The net of all this history, I am pretty sure, is that today’s sophisticated investors are not willing to pay very much for the ability of insurance managements to make capital gains for them over the years. It turns out that we do not have the type of check-ups and careful analysis of insurance company investment results that we have in the case of investment trusts, because the business does not lend itself so easily to that kind of thing. But it can be done. I am going to give you some figures on American Equitable Insurance Company over a 20 year period, to indicate how that company made out of that period of time with its investments as well as with its underwritings.

But on the whole, just answering the specific question asked, no investor today — and I don’t think any analyst — is willing to give the insurance business any special credit for ability to make profits on the principal value of its securities. It will make profits in good years and it will lose money in bad years from that department. That may be doing it an injustice; but that I am sure is the general opinion of security analysts at the present time.

*** QUESTION: Would you care to take a minute to differentiate between premiums and underwriting profit? That is a little technical. What is underwriting profit?

MR. GRAHAM: Underwriting profit is the profit earned from the insurance business as such. It consists of the balance left after you pay the losses and the expenses of the underwriting business. It includes, moreover, a certain component known as the increase in the unearned premium reserve, which is a technicality. It is generally accepted that the liabilities shown on the balance sheet for “unearned premium reserves” include, to the extent of 40 per cent ordinarily, an amount that is really the stockholders’ equity. When that figure goes up, the insurance profits for the year are increased accordingly, and conversely. Thus you really have two parts to your underwriting results: One, the straight result, and the other the equity in the increase or decrease in the unearned premium reserve.

I do want to say something about the method of calculating liquidating values, or equities, in this business, but I will delay that for a while.

QUESTION: What of the possibilities of increasing the underwriting profits, rather of raising rates in underwriting business? You always get a lull after a war, when the insurance on property has to be marked up after the replacement value advance.

MR. GRAHAM: In answering that question now, I would like to distinguish very sharply between recent results and long-term average results. The recent results of the fire business have been bad. Most companies, I think, showed losses for 1946 — the figures are not out yet — and about half of them, perhaps, showed losses for 1945. The results that I have been dealing with have been ten-year average figures, and I think that they pretty fairly represent what you can expect over the years in the insurance business. It may be that the results will be a little better in the next ten years than they were in the last ten years, but I don’t believe that an insurance analyst or an investor ought to count particularly upon that. He should count upon their being better in the next five years than they were in the last two or three, which is of course a different matter.

QUESTION: Why do companies like the American Reserve or even the North River stay in business, then?

MR. GRAHAM: The North River Company stays in business, of course, because it has been in existence for 126 years, and has built up a large business, which has increased over the years, which has been satisfactory to the people running the business, to its agents, and to its policyholders. Whether it is now satisfactory to the stockholders I don’t think has ever been asked, and I don’t think such questions are asked in any of these companies.

I have read a number of reports of fire insurance companies to their stockholders. They consist generally of a one-page balance sheet and a few pages listing the securities owned. The question of how profitable is the business, is just not discussed. I suppose it would be ungentlemanly to raise the point.

QUESTION: Do your figures here show underwriting profit as reported, or is some adjustment made such as the Best adjustments for unearned premiums?

MR. GRAHAM: These include the unearned premium adjustment, which is pretty standard. In fact, the companies themselves, in many cases, indicate what that amounts to in their discussions at their annual meetings. It is really standard procedure In the casualty business there is still another adjustment, which I will mention later on — the difference between one kind of reserve and another kind of reserve method.

QUESTION: Well, one of the reasons for stockholders not knowing anything about insurance companies is the fact, that I think, until recently they didn’t publish any profit or loss statements. They just gave balance sheets on the statement, just like the bank did.

MR. GRAHAM: Yes. If I were a stockholder in an insurance company, I would like to know whether the business was profitable enough, and I would ask. But apparently the stockholders in the insurance companies don’t ask that question, to the extent of requiring that the figures be analyzed or presented in the annual reports.

The casualty companies, interestingly enough, tend to publish rather elaborate reports, with a good deal of information. One reason, perhaps, is that the casualty business has been quite profitable in the last ten years.

QUESTION: Don’t you think the stockholders’ complacency is caused by the fact that the early investor in insurance companies — such as continental, or what is called the “Home Group” — has done very well over the last twenty years with his money. Whether he has been lulled to sleep is another thing, but I think that has been the cause of it.

MR. GRAHAM: I am not in a position to tell you what happened in the last twenty years to every one of these companies. But I do know that in the fire group some companies have done very badly for twenty years; and a company like North River, which I believe is pretty representative, has started off doing very well and is finishing up in a situation which does not permit it to do really well for its stockholders. I don’t believe that this analysis would be subject to much change if you took other companies. You might find one or two exceptions, such as the St. Paul Fire and Marine. But they are extraordinarily few.

QUESTION: Is the competition of mutual a factor here?

MR. GRAHAM: I don’t know whether that really is a factor. It might be. But the insurance companies endeavor to obtain higher rates when they need them by application to the various insurance boards, and there is always a lag in getting them.

QUESTION: The solicitors for the mutual insistently cite expenses cheaper than the stock company. That is one of their big points. That is to say, in the form of commissions to agents. Net costs to the policy holder.

MR. GRAHAM: I shouldn’t be surprised if that were so. There is reason to believe that the scale of commissions paid on fire insurance policies has been too high — the commissions paid to agents. It doesn’t take a great deal of salesmanship in my opinion to sell a fire insurance policy. It does take quite a bit perhaps to sell a life insurance policy. The fire commissions have been pretty large, and I think that in some cases recently the state insurance departments have hesitated to permit premium raises on the ground that the commissions to agents have been too high. At least so I am informed, but I will not state that as a fact.

QUESTION: The casualty men always stress cost to the policyholders.

MR. GRAHAM: In the mutual, too? Well, in the casualty field, in spite of the competitions with the mutual companies, the stock companies have been able to earn a very considerable sum of money for their stockholders. Are there any other questions about that?

QUESTION: To get back to a point that might be elementary. I am not at all familiar with these industries. You have 1927 and 1945 statistics on the board. I can see why there has been a decline in investment income; but even if it is repetitious, will you explain why there has been that sharp decline in underwriting profit, and whether that is a transitory situation or will it continue?

MR. GRAHAM: The decline in the underwriting profit of North River is due to two factors: One is the profit per dollar of insurance written, which went down from about six per cent to four per cent for those two years. It is difficult to say whether that is a permanent thing or not. I am inclined to think that there is a slight tendency for that rate to go down through the years.

The more important fact is that the amount of premiums written by this company, per dollar of stockholders’ equity, has been cut in two. Therefore, with the same rate of profit you would only earn half as much on your stock. That is just like saying you now have only 50 cents of sales per dollar of capital, instead of a dollar of sales.

The reason for that is very interesting, and I would like to comment on it a bit. What has happened is that these companies have built up their stockholders’ equity in various ways in the period to a much greater extent than they built up their premiums. The result is that from the standpoint of good results for the stockholders, they seem to have much too much capital per dollar of business done in 1945.

Of course, the insurance companies will insist that is not true. They will say that the more capital they have the better the policyholders are, and therefore the better the stockholders are. They will also say that they expect to do very much more business in the future, and therefore they should have the capital available for the expanding business. But the fact remains that in dollars and cents you have the situation that the North River Company had $25-million of stockholders’ capital and did about $9-million of business in 1945, which is a very small amount of business per dollar of capital. In 1927 they did a somewhat larger amount of business with less than half the amount of capital.

No attention has been paid to that matter by anyone, that is by any stockholder. As far as the management is concerned, the more capital they have, the better off they are. There isn’t the slightest doubt about that.

QUESTION: Haven’t they got more money to invest in stocks?

MR. GRAHAM: They have more money to invest in stocks, but that is no special advantage to the stockholder because he has more money of his own invested. The question is what about the rate of return, and that has gone down too, of course.

There is a better answer to your question. Because they have more capital, the amount of investment per dollar of capital goes down. The reason is that in addition to investing the stockholders’ capital they invest other moneys that come out of the conduct of the business. The more capital there is in relation to the business, the less proportionate excess do they have. That is shown in this figure: In 1927 they had $1.45 of invested assets per dollar of stockholder’s capital, and now they have only $1.18. So they lost out in that respect too.

Now, I might suggest that somebody should raise the question, “What can the stockholders do to get a decent return on their investment on the North River Insurance Company?” Let us assume it was a matter for the stockholders to decide, which would be a very extraordinary suggestion for anyone to make — elementary as it sounds in theory. Here is a possible answer: Suppose you re-established the relationship between capital and premiums that existed in 1927, when things were quite satisfactory, by simply returning to the stockholders the excess capital in relation to the business done. If you did that, you would be able to get the earnings of about six per cent on your capital and to pay the four per cent dividend on your capital, which I suggested might be a definition of a reasonable return to the stockholder. That could happen because, when you take out $15 a share from the present $31 — and you have left only $16 to earn money on for the stockholder — you are reducing your earnings only by the net investment income on the $15 withdrawn, which is on the order of, say, 40 cents at the most. Thus you would earn about 85 cents on the remaining investment of $16 and you would get reasonably close to the six per cent which you need.

That is a method that will not recommend itself to insurance company managements, but which at least has some arithmetical validity as far as the stockholders are concerned.

Are there any other questions about this analysis with regard to the North River Company?

QUESTION: I don’t quite understand. What is the reason for the decline in the volume, dollar volume, of premiums underwritten? Is it a question of growth and competition in the industry? Would you not expect the over-all dollar amount of premiums to increase over a period of 20-odd years?

MR. GRAHAM: The situation is this: For the country as a whole net premiums written by fire companies grew in volume from $966-million in 1927 to $1,226-million in 1945. That would represent an increase of about one-third.

The North River Company had $9.1-million in premiums in 1945, and $10.9-million in 1927. That was a reduction of about 16 per cent. It is pretty clear that the North River Company individually went back in that period of time. Many of the other companies, which increased their premiums, however, increased them by absorbing other companies over the 20-year period. Also a good deal of the insurance written was taken by new fire subsidiaries of casualty companies, and so on. It may well be that the typical company which didn’t go through corporate changes, but just stuck to its old setup, might have had a situation not so different from the North River Company, namely, a decline in premiums.

It is important to point out that the rate of premiums per $1,000 of insurance went down very much from 1927 to 1945. The companies gave more to the policyholder for their money. The result is that their premium income suffered, and does not reflect the true growth in the amount of coverage extended.

QUESTION: Did North River sell additional shares during that 18-year period?

MR. GRAHAM: Yes. I made an error in my previous statement that I want to correct. I said that the North River Company had retained its old position. That was not right. They took over another company, which represents about one-fifth of their total capitalization. That means they added about 25 per cent, presumably, to their business by absorbing another company in that period of time, so they should have shown an increase in their business. Exactly why this company didn’t do it, I don’t know.

QUESTION: Isn’t the North River one of a group of companies?

MR. GRAHAM: Yes, it is operated by the Crum and Forster organization.

QUESTION: They may have stuck the premiums in some of their other companies.

MR. GRAHAM: That might be the reason. That is another interesting question that arises in the treatment of stockholders’ interest by insurance company managements. Many of the insurance companies are part of so-called “fleets” or groups of companies, and you find some very surprising things in those fleets. Some of the companies tend to be quite profitable, and others in the same group tend to be unprofitable. When you ask for an explanation, as I have done in one case, you may be a bit surprised at the kind of explanation you get. The thing that surprises me always is that the insurance people never talk in terms of what happens to the stockholder. They always talk in terms of what happens to the business as such. You can find many business reasons why Company A should be profitable and Company B should be unprofitable — but no reason that will satisfy the stockholder of Company B, in that case.

Link

Disclosure (“none” means no position):
Visit the ValuePlays Bookstore for Great Investing Books