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Lecture Number Six
The first thing that I want to make clear in any attempt to obtain a view as to future earnings, either in general or in particular, is that the analyst is not really trying to look into the crystal ball and come out with the correct answer for the period of time that he is forecasting. What he is really trying to do is to determine how the analyst should act and think — that is, how far he can go in logical thinking with respect to the always enigmatic future.

I don’t believe any of us have the pretension of believing that by being very good analysts, or by going through very elaborate computations, we can be pretty sure of the correctness of our results. The only thing that we can be pretty sure of, perhaps, is that we are acting reasonably and intelligently. And if we are wrong, as we are likely to be, at least we have been intelligently wrong and not unintelligently wrong. (Laughter.)

*** In a study of fourteen companies which I made — mainly those that appeared in the Dow-Jones Average, either before or after 1914 — I found that seven of them showed larger earnings in the post-war period than before the war, six of them showed lower average earnings, and one of them was even. That one, incidentally was United States Steel, which had widely fluctuating earnings in the period after the war, but which averaged in those five years the same figure as it did in the preceding three.

Those results were not as satisfactory as they should have been, because in that period we had the very serious depression of 1920 to 1922; and the effect of depressed conditions was to reduce the average earnings well below what they would have been if we had had a level period of national income. You recall that the figure of $62-billion, which I gave you, was an average national income for the five years. But there were rather wide fluctuations from year to year, and the effect on earnings as a whole was bad. You do not gain as much from periods of unusual prosperity as you lose in periods of depression when you are in business. That is almost an axiom.

*** I am more and more impressed with the possibilities of history’s repeating itself on many different counts. You don’t get very far in Wall Street with the simple, convenient conclusion that a given level of prices is not too high. It may be that a great deal of water will have to go over the dam before a conclusion of that kind works itself out in terms of satisfactory experience. That is why in this course we have tried to emphasize as much as possible the obtaining of specific insurance against adverse developments by trying to buy securities that are not only not too high but that, on the basis of analysis, appear to be very much too low. If you do that, you always have the right to say to yourself that you are out of the security market, and you are an owner of part of a company on attractive terms. It is a great advantage to be able to put yourself in that psychological frame of mind when the market is not going the way you would like.

*** There are great advantages in dealing with a group valuation, because you are more likely to be nearly accurate, I am sure, when you are considering a number of components together — in which your errors are likely to cancel out — than when you are concentrating on an individual component and may go very wide of the mark in that one.

Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did.

When we talk about buying bargain issues, for example, the emphasis on group operation becomes even greater, because you then get into what could practically be know as an insurance type of operation. Here you have an edge, apparently, on each individual company. That advantage may conceivably disappear or not be realized in the individual case; but if you are any good at all as an analyst you ought to realize that advantage in the group. And so I have had a great partiality for group operations and group analysis. I must say, however, that you gentlemen, as functioning security analysts, advisers to the multitude, and so on, are unable to obtain that advantage in all the work you do. For I am sure you are compelled to reach rather definite conclusions about individual companies, and can’t hide them in a group result.

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Lecture Number Five
As a preliminary perhaps I might answer any questions that are in your mind growing out of the last lecture, which ended rather precipitously. Does anyone have anything on his mind? We were discussing the Childs’ valuation by the Securities and Exchange Commission. At that time, you will recall, we had indicated that the SEC had valued the Childs Company primarily on the basis of its future earning power, which was the thing that interested us, but had added a certain amount for excess working capital — actually $1.3 million net after paying the bonds. Let me make the point here that a security analyst would not be inclined to add in the excess working capital to the valuation of the property unless he believed that the money was to be returned in some way or other to security holders. As a matter of fact, some part of the excess working capital was to be used to pay off the old debt of Childs, and that portion, of course, represented an addition to the earning-power value of the old company. Thus our own “practical” valuation would tend to be $9 million rather than the $10 million found by the SEC.

Since we discussed the matter two weeks ago, the Federal Court has approved the Childs plan, based upon the modified proposals of the trustee; and it has apparently placed the stock equity at $9.98 million, which is $300,000 less than the amount that the SEC found.

It may be interesting to look a bit at the prices of the securities, to see what they indicate as of now. The preferred and common together were selling for about $8.4 million yesterday, preferred at 155 and the common at 7 1/8. This is less than the valuations that we have been talking about. There is nothing surprising about that, of course; because it is a normal experience to have the securities of a company in trusteeship sell at less than the valuations that an analyst would find for the property on a reorganized basis. It would be expected that the value would normally increase over a period of time — such as one year or two years, following trusteeship, — as the enterprise gains its proper position in the public’s esteem. That is almost an invariable experience.

*** Here we have a five page discussion of American Radiator, in which a great deal of information is supplied on the industry, — not only its past, but future calculations, based upon somebody else’s estimates for the year 1947; and also some other estimates for the years running between 1946 and 1951, on the demand and supply of new houses.

Then they take up the earning power of American Radiator Company; and for the first time in this group of analyses that we are speaking of they actually endeavor to determine what the value of the company would be, based on assumptions as to earning power and as to multipliers. Their method is as follows: They project sales at the rate of $10 million; and this, you see, is our now familiar Childs Company method. Then they apply a profit margin, which they expect to be fifteen per cent. Then they say, “Net per stock: $1.40 per share.” They do not give you the arithmetic of that, but here it is: Net before taxes would be $24 million, less taxes at about 40 per cent, brings it down to about 14 million-odd, and that is about $1.40 on ten million shares of stock. Then they add: “Foreign earnings, estimated 25 cents” — and that is a very rough estimate. So they get $1.60 to $1.70 per share, total. Further, they state that the relatively near future, — and because these favorable earnings should continue over a considerable period of time, the stock of this company should prove to be relatively attractive even at its present level, the “present level” being about 20, in February, 1946.

That analysis was later use by a stock exchange house, which concluded, without needing quite as much courage, that the stock looks relatively attractive at 15, which was the price on October 23, 1946.

Now before I attempt a criticism, not necessarily unfavorable, of this analysis, I may as well go on to the last one that reached my desk, which is headed “Active Years Ahead for the Building Industry.” It gives a great deal of information on the building industry, and information about the companies in the industry, including American Radiator, which is the first one. There they make a calculation of the earning power of the company in what they call year 194x, which they figure at $1.75 per share. They use an expected profit margin of 12 per cent. There is a little discrepancy between the 12 per cent and their final result. It can be explained, if you want to go to the trouble, partly because they take into account foreign earnings to a greater extent than did the research company analysis. Now, the interesting thing about this analysis is two-fold: First they get earnings of about $1.75, which is not so different from the other projection. But they describe that estimate as follows: “A rough guess of potential earning power under optimum conditions over the next few years is shown by the line designated 194x.” In the rest of the circular, while not too specific, they imply that these stocks are attractive, the ones that they have listed, because of the expected earnings in the 194x year. That is particularly true because the price of American Radiator was only 13 1/2 on that date, and the estimated earnings of $1.75 would make the price of 13 1/2 look quite reasonable if that represented future earning power.

My comment on these analyses — the last two ones, which are the only ones that seriously attempt a projection of future earnings — is this: They do not emphasize enough the fact that the earnings they are dealing with are earnings of a boom period; but the technique of analysis should take that carefully into account.

The earnings for the building boom should be evaluated pretty much in the same way as we were accustomed to evaluating war earnings, that is to say, by assuming that they were to last for a limited number of years. The excess earnings during that period should be added to what we would assume to be the normal valuation of the company based upon its average peacetime earnings. Thus, if you want to attempt a serious evaluation of a company like American Radiator, the only proper method is to take what you would assume to be its normal earning power, not its optimum earning power, evaluate that, and then add to it a fair allowance for the fact that it is facing some very good years.

I might say that if you want to be somewhat pessimistic you could criticize even that method; because you might argue that these boom years are simply part of a building cycle period, — they are not really excess earnings; they are the good part of the normal earnings and will be offset by very low earnings when the building boom subsides. That comment may be justified; but in any event the method that I spoke of before seems to me to be as liberal a method as you could use.

You had a question about that?

QUESTION: What makes you say that in that estimate of $160 million of sales, those factors were not considered?

MR. GRAHAM: You mean the fact that they were boom period sales?

QUESTION: Possibly they did consider that.

MR. GRAHAM: I can give you a specific reason for that. They say that the earnings are related closely to the residential building totals that will be expected. And over the period 1946-51 they have gone to the trouble of giving you a projection of the amount of buildings needed and the amount that will be supplied. During the years 1947-51 they are expecting a million units of building annually. At the end of that time the deficiency will be completely remedied; and, on the basis of their statistics, demand would be reduced to somewhere around 550,000 buildings a year, that is to say, about half a million new families plus demolition. Following through this calculation to the year 1952, you would find that the expectation of new units would be not more than half of the one on which they had based their $160 million of sales.

Another reason, of course, is that the sales actually realized in 1939 were only $80 million, and in 1938 $68 million. Thus the volume of $160 million, even allowing for some increase in prices, would obviously be on the high side.

Were there other questions about that? Questions of this kind are very good, because they help clarify the reasoning behind these evaluations.

It seems to me that the method of evaluation, then should be somewhat different for American Radiator than has been used. You ought to start, not with the optimum earnings, but what you would consider to be normal earnings for the company. The company had been earning on the order of about 50 cents a share in the period before the war; and I would assume that if you take earnings of a dollar a share after the war, you would be about as optimistic as you would have any right to be about this company’s earnings after the building boom has subsided. I am inclined to think that is over-optimistic, as far as one can see now, for the very reason that when the building boom has subsided you are likely to go into a period of subnormal earnings if the building cycle behaves in the future as it has in the past. But if you accept the one dollar earnings — and I really want to mark that as liberal, — I think the multiplier would be somewhere between 12 and 15. That is higher than the company’s past record would justify, — but the American Radiator has some advantages in being a large and strong company, well thought of, and which many years ago was a very large earner. Consequently, I think you would get a valuation of $12 to $15 on a normal basis.

To that you would add an allowance for the boomtime earnings, which are 75 cents a share over expected normal. If you multiply this by four you are again pretty liberal; that will give you three dollars extra. The valuation, thus comes to about $15 to $18 a share for the stock, giving the company the benefit of certain doubts that I would have in my own mind. This valuation, I think, could properly have been made for American Radiator at any time during the past year, and would have justified caution with regard to a purchase of that stock for investment at the prices of early 1946.

But on that subject let me add that it is perfectly proper to buy stocks for speculation. There is no crime in that. When you buy stocks for speculation it is perfectly proper to take speculative factors into account, which are different from investment factors. The normal expectancy would be that if this company is to earn $1.75 a share for three or four years, the market will reflect those earnings in full on a speculative basis, without making allowance for the fact that they are temporary.

That hasn’t always happened. For example, during the war the market certainly didn’t reflect war earnings on the theory that they were permanent earnings. But the market does tend to do so with regard to cyclical earnings; it regards the boomtime earnings as permanent earnings. For that reason it is quite possible that American Radiator could sell, under good general market conditions and during its own boom period, at a price very much above our value of 15 to 18.

We must not forget that American Radiator as recently as 1942 sold at 3 3/4. What we are saying is that American Radiator is a speculative type of security by the nature of its business, as well as by the fact that it is a common stock. Just as it can sell at four dollars in bad year, it can easily sell at $30 in a good year, and both prices would be fundamentally justified. Our own valuation represents the type of investment approach which tends pretty much to bring you what you would consider to be a central value for the stock. This interests the investor primarily; but second it may interest the intelligent speculator too. For he could then see how far he is getting away from central value when he is following up the speculative aspects of the situation.

I welcome questions about that, because I think that is very important.

QUESTION: If we are to estimate future earnings for just a period of five years, when you speak of a normal period for this industry, wouldn’t your analysis go beyond that five-year period? The boom years might be the next five years. Then if you are striking for a normal level, that would go beyond the next five years; so as a result your earnings in the coming five years would be on a higher level and your normal period lower.

MR. GRAHAM: Yes, you are right in making that point. If my recollection is correct, I did make that point too, in my third lecture. I said that normally the earnings that you are trying to estimate are those of the next five years, — perhaps five to seven years, — but that there might be some exceptional cases. And I did have the building industry in mind, in which the next five years would not be regarded as a normal expectancy. The analyst is under a special disadvantage, then, because the normal earnings that you are thinking of lie so much further ahead in the future that your chance of being wrong in calculating what they are going to be is that much greater. But there is no help for it. You cannot properly evaluate the boom earnings of the next few years as normal; so you must jump ahead to the later earnings.

QUESTION: But when the market regards the earnings of a company, if the company went along for five years at a high rate of earnings, then wouldn’t the market place a higher valuation on those earnings, considering the length of time the earnings would be at that high level?

MR. GRAHAM: Yes; because the market would tend to multiply the earnings by your standard multiplier of 15 or thereabouts, instead of merely adding them in the way we suggest you do. (I am speaking, now, of the abnormal or excess component of those earnings.) The investor would then be out of step with the market in his attitude toward a stock like American Radiator.

The investor is very often out if step with the market, incidentally, and that would be no new experience for him. But I think it is useful for the investor to have some idea of what would seem to be the reasonable value, even if the current market may not reflect it at all.

*** A thing I would like to warn you against is spending a lot of time on over-detailed analyses of the company’s and the industry’s position, including counting the last bathtub that has been or will be produced; because you get yourself into the feeling that, since you have studied this thing so long and gathered together so may figures, your estimates are bound to be highly accurate. But they won’t be. They are only very rough estimates, and I think I could have given, and probably you could have given me, these estimates in American Radiator in half an hour, without spending perhaps the days, or even weeks, of studying the industry.

*** I want to say finally on this question that an elaborate forecasting technique has been developed in recent years on the amount of dollar business and physical volumes that would be done in various industries at certain levels of employment, or certain levels of gross national product. The Committee for Economic Development has gotten out studies of that kind which gives you estimates of the industry totals under full employment conditions, and the same has been done by the Department of Commerce. Those of you who want to go into that aspect of analysis should start pretty much with these forecasts, and accept them or reflect them as far as your own judgment is concerned. If you accept them, then build your forecast of the individual company’s sales in relation to the industry totals which you are starting with. You may make three different estimates, — as is now done sometimes — based upon full employment, moderate unemployment, and considerable employment; and make your estimate of sales accordingly. That is the new technique, and I think you will find it interesting as applied to security analysis.

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Lecture Number Three
Now there is one other item that came to my attention a few days ago which has a bearing on war accounting and that is a reference to what is known as “Lifo,” which means last in, first out. I presume most of you are familiar with that accounting principle. It has had a rather important effect upon the balance-sheet figures of some corporations, but not quite so important on their income accounts.

Lifo is an accounting method, permitted by new income-tax regulations beginning about 1942, under which instead of considering that the first purchased merchandise is sold or used up in manufacture, the corporation is permitted to assume that the last purchased merchandise is sold or used up. As a result, the inventory is kept down during a period of rising prices because it is not necessary to mark up the value of the quantities of inventory owned at the time that the rising prices began. The result of using that method is (a) to reduce inventory values below market values, and in some cases by a very considerable amount; (b) to reduce accordingly the reported profits; and © and most important, perhaps, to reduce the amount of taxes which have to be paid.

What you have, then, in the balance sheets is either an understatement of the true value of the inventory, if you want to consider it that; or a cushion to absorb declines in inventory values without effecting a cash loss if you wish more conservatively to consider Lifo that way. In the case of the Federated Department Stores, their report which appeared a few days ago gives some details on Lifo, which they find necessary to do because of a tax problem facing them. That company showed that since 1942 they had the benefit of a reduction in inventory and taxable profit of $3,875,000 by using Lifo instead of using the usual first-in, first-out method. That enabled them to reduce their taxes by $2,590,000; and it reduced their profits after taxes for the five and a half years by roughly $1,150,000.

The difficulty that they refer to is the fact that in department stores it is practically impossible to identify the items that are sold in relation to just when they were bought. Consequently the department stores have tried to use something called an “index of retail price changes” to determine what would be the effect of Lifo on their accounting. And they now are in a controversy with the Treasury because the Treasury says that the Lifo section does not permit the use of estimates by means of an index as to what last-in, first-out means, and therefore they must go back to their old method of first-in, first-out.

The significance of Lifo is interesting, when you reflect upon it, because it is very similar to the wartime amortization of plant facilities which we discussed two weeks ago. There, you recall, the companies had the opportunity to write down their fixed assets, which were recently acquired, to zero, and to get the benefit of tax credits, the effect of which, however, was to reduce their earnings somewhat. You have exactly the same effect here in Lifo. You write down your inventory, save a great deal of money in taxes, but reduce your apparent earnings somewhat.

I think that for the analyst the signifay that here is a company that had done a great deal to improve its situation in five years, and the market doesn’t reflect that at all. But on the other hand it is not at all clear that it should reflect it, because now in 1946 the company seems to be back pretty much where it was pre-war, with no substantial earnings.

That is what I would call a conventional current analysis of Northern Pacific, but I think it is quite superficial. There is a good deal more to that situation.

When you look a little more closely at Northern Pacific you will find that the main factor affecting this company, that does not affect other companies, is its large interest in an affiliated railroad which is not shown in its income account, except in the form of dividends. Northern Pacific owns 48 1/2 per cent of the Burlington, or C.B. & Q. Now, the Burlington is rather paradoxically bigger and a much better railroad than the Northern Pacific. You have thus a rather unusual situation, in which the chief interest perhaps of the stockholders of the Northern Pacific does not appear except in a very indirect and incomplete way in its own reports.

In addition to that interest in the Burlington the Northern Pacific owns 50 per cent of a rather substantial railroad system called the Spokane-Portland-Seattle, which before the war had no earning power but which during the war had quite substantial earnings. In addition to that, the Northern Pacific has a land department which has been productive of rather substantial income over the years. This does not appear in the income account but the proceeds or profits are credited to surplus directly. When you start taking account of these additional interests of the Northern Pacific you find that the picture is quite different than it appeared in the first analysis. In the period 1936-1940 there would be no substantial change, because the Burlington paid out practically all that it earned in that period. Instead of having a small loss on the stock you would have an equally minor profit of about 12 cents a share.

But when you take the war period 1941-1945, you find that to the $6.20 average shown by Northern Pacific there is to be added $3.80 per share in undistributed profits of Burlington; about 86 cents per share representing the earnings of S.P. & S.; and about 60 cents per share representing the land department — giving you a total of $11.46, which is pretty nearly twice the figures actually reported. These are average earnings per year for five years. Thus you find that there is what used to be called a “hidden equity” of about $26 a share additional in those five years, making a total of about $53 that has gone back into the stockholders’ account for Northern Pacific as compared with the pre-war period.

If you look at the Burlington you will see that its own undistributed profits show up in a considerable reduction in funded debt, a reduction of 36 per cent in fixed charges, and a considerable increase in working capital. You would find that the earnings of the Spokane railroad show up in the form of $20-million additional working capital, of which $10-million inures to the Northern Pacific.

When you come to the period of the first eight months of 1946, you find that instead of having earnings only 74 cents a share, the earnings, including the Burlington equity are $2.80 a share for the eight months. The indications are that they will earn about five dollars a share for the full year, including the Burlington equity.

That, of course, is a very different picture from the rather negligible earnings which they reported for the first eight months. You have also some figures that have been put in the record with the I.C.C. in connection with the rate-increase application. These show that if they get a ten per cent further increase, (which is more or less the figure that Wall Street is expecting or hoping for, ) they might earn about four dollars per share in 1947 on their own income account and perhaps eight dollars a share, including their equity in the Burlington.

Now, those are very substantial figures in relation to the current market price. They indicate the importance of looking at the railroad on the consolidated basis rather than on the basis of the earnings as they were reported.

An interesting further study of Northern Pacific could be carried on by comparing it with some other road. This would give you some idea of its relative position and its attractiveness. I would suggest therefore that we devote a little time to a comparison between Northern Pacific and Southern Pacific. There is a relationship in names there that would make the comparison a natural one.

You might suggest that the comparison should be made with Great Northern, because Northern Pacific and Great Northern have always been grouped together in general railroad analysis, and you know that each of them owns approximately half of the Burlington. However, the Great Northern has managed to put itself into a stronger capital structure position than Northern Pacific, partly through the conversion of bonds into stock. The great Northern belongs somewhat more in the investment category. On the other hand, as we shall see, Southern Pacific is about in the same general financial situation as Northern Pacific with respect to stock and bond capitalization structure. That is a fundamental basis of allocating roads to classes for comparison. As you know, Northern Pacific sells now about 19, and Southern Pacific about 42. There you have a ratio of somewhat more than two to one. If we go back to the superficial earnings, you would see that before the war Southern Pacific averaged $1.27 per share for five years, 1936 to 1940, while Northern Pacific had a very small deficit. In the five years 1941 to 1945 Southern Pacific showed $12.90, against $6.20 for Northern Pacific, which is about our ratio of two to one; and in eight months of 1946, Southern Pacific shows $3.86 against 74 cents for Northern Pacific, which is much better than a two to one ratio.

STUDENT: Does Northern Pacific use its carry-back in the first eight months the way Southern Pacific did?

MR. GRAHAM: That’s a point that I shall come to. We have just spoken now about the figures as they appear in the reported earnings picture per share. Now we make two adjustments for that, one of them being the question of taxes which has just been raised. You find when you study the Southern Pacific figures that in 1946 they have had a tax credit of about $19-million, which is more than the earnings reported for that period. Northern Pacific had a small tax payment of its own and fairly substantial taxes for Burlington; so that they do not use any tax credit but, on the contrary, pay full taxes on their earnings.

If you compare the situation, putting in Northern Pacific’s Burlington interest, you would find that while the 1936-1940 figures remain about the same, for the war period Northern Pacific’s earnings rise to $11.46, as compared with $12.90 for Southern Pacific, — very nearly the same. For the eight months of 1946, Northern Pacific’s earnings before taxes without allowances for income tax debit or credit, would be $4.60, while those of Southern Pacific would be a deficit of $1.20.

In a peculiar way, therefore, the situation seems to have been reversed. Whereas before the war Northern Pacific apparently tended toward a deficit and Southern Pacific toward moderate earnings, we now find that under 1946 conditions Southern Pacific seems to be tending toward a deficit and Northern Pacific toward fairly good earnings.

That analysis, of course, calls for much further probing into the situation. You have to ask yourself why it is that you get these diverse developments in the different periods that we are studying. What you find is that Southern Pacific in 1946 has apparently lost control over its expense ratio more seriously than has happened to Northern Pacific and to Burlington. As a matter of fact, the Burlington has been doing a very nice job of maintaining its net earnings even under the unfavorable wage and rate situation which we have had in 1946.

Northern Pacific itself has not done so well, but it has done better than Southern Pacific; and the combination shows up very much better. As you study the figures more carefully, you find that an advantage which Southern Pacific seemed to have developed in its operating ratio during the pre-war and early war years has now seemed to have reversed itself or disappeared; and the advantage is now in the Northern railroads.

If you study the Southern Pacific figures over a period of time, you will see that of course the Southern Pacific derived great advantages out of the war. It increased its surplus and its working capital considerably; it decreased its debt a great deal, and cut its fixed charges by about 20 per cent. That figure is not quite as good as the decrease shown by the Northern Pacific-Burlington combination.

Another factor that should get attention from the security analyst in studying these railroads is the question of rentals and hire of equipment. In the ordinary way in which fixed charges are stated in the manuals, and elsewhere, you would get the impression that the coverage of fixed charges for Southern Pacific is quite a good deal better than that of Northern Pacific — or was, let us say, up to this year. Actually that is not the case if you consider rentals and hire of equipment, (with payments and receipts), as part of your over-all fixed charge situation.

Those of you who have studied our text on Security Analysis will recall our reference to the “net deductions method” in which you replace fixed charges by a figure representing the difference between the net after taxes and the balance for stock.

On that basis you will find that Northern Pacific has a considerable advantage, because it has regularly received substantial credits from hire of equipment and joint facilities. In 1945 these were $4,346,000. But Southern Pacific has made very heavy payments for the same purpose; in 1946 they were $24,600,000.

If you restate your fixed charge coverage by allowing for the equipment and joint facility rental payments and also put in Northern Pacific figures its share of the Burlington, you will find this situation is also true for the eight months of 1946. Southern Pacific’s net deductions were $24,300,000 in eight months, which was about seven and a half per cent of gross, the latter being around $320-million.

Northern Pacific’s net deductions were $9,180,000 on gross of $143-million. This is on a pro-rata consolidated basis, which includes 48 1/2 per cent of Burlington. Thus you would find that the ratio is on the order of six and a half per cent of gross. The relationship to net is better for Northern Pacific than for Southern Pacific, because Northern Pacific’s operating ratio is less.

These are factors which I am calling to your attention because they do not enter generally into the analytical presentation of a railroad’s showing. And you find that when you allow for these factors you get a very considerable difference in the picture than when you started with the figures that were first available.

*** One very good reason why Southern Pacific sells so much higher than Northern Pacific is because it is paying dividends at the rate of four dollars and Northern Pacific is paying dividends at the rate of one dollar. It is obvious that such a disparity in dividend policies would have a substantial effect on market prices.

A question that we shall have to consider from time to time in the future is how valid is the dividend rate as a determinant of proper market prices. That it actually has a great effect on market price cannot be denied — certainly in the field of securities that are bought by investors. Two years ago, when we were giving a course here on appraisal of stocks, we had occasion to compare Reading and Pennsylvania. There we found that Reading and Pennsylvania made practically the same showing with regard to earnings and financial strength. But Reading was satisfied to pay a dollar to its stockholders, while Pennsylvania was paying about two dollars and a half. The result was that you had prices averaging $20 for Pennsylvania in 1945, against $24 for Reading. Before that time, I think, the ratio of prices was about two to one, although the ratio of earnings was about the same.

I have also had occasion recently to see rather startling evidence of the effect of dividend policy on prices in a number of the insurance companies. If you take two companies like New Amsterdam Casualty Company and the United States Fidelity & Guaranty, you would find that these companies are almost identical in every respect, in the character of their business and their assets, except that one of them has twice the amount of stock and twice the assets and business. The earnings per share are about the same. But United States Fidelity pays two dollars and New Amsterdam Casualty one dollar, and so you have a relationship in price of $42 for one and $26 for the other.

There is no doubt, therefore, that the dividend rates of Southern Pacific and Northern Pacific are sufficient to explain the market relationship, even by themselves, without reference to any other questions that the analyst might ask himself.

We must consider later — but I don’t think we shall do it now — whether the analyst can take advantage of the fact that two companies would be worth, say, approximately the same amount from every standpoint other than dividends, and sell at considerable difference because of dividend policy. The question that would come up is whether you can expect in the normal course of events that the dividend policy will adjust itself to the earnings and that therefore eventually the market price will adjust itself to the earnings and will not be determined by an arbitrary dividend policy. That is a very difficult question to reach a conclusion about, and I prefer to talk about it at some other time.

*** STUDENT: One of the appraisals that I hear is that since Southern Pacific is so largely in the Southwest, Texas, in a territory that is growing much more rapidly that the Northwest territory, that some rail analysts are strong in their preference for Southern Pacific on that basis over Northern Pacific.

MR. GRAHAM: There is an undoubted impression that the future of the Southwest territory is better than that of the Northwest territory. You have some justification for that in the most recent figures of development of gross earnings. I would like to give some figures on that which would show how these companies have developed over the last ten years in relation to volume. In 1937 the gross of Northern Pacific, plus 48 per cent of Burlington, was $113,500,000 and Southern Pacific was $225-million. That is almost exactly two to one.

In 1941, Southern Pacific showed a slight increase in the ratio — $147.3 for Northern Pacific versus $297.8 for Southern Pacific. By 1944 Southern Pacific had drawn quite a bit ahead of the Northern Pacific combination. In 1944 it was $254-million for Northern Pacific and $597-million for Southern Pacific. And that advantage has persisted up to 1946 for the first eight months.

The question that one would raise about those figures is the extent to which they have reflected the impact of war conditions since 1941, and whether or not they would be expected to continue in the future. Frankly, I don’t know what the answer is. Furthermore, I don’t know how important such changes with regard to gross earnings may be in the final earning power of the railroads.

One of the anomalous things — and this is very extraordinary — that you find in your analysis is the following: In 1937 the net earnings of Northern Pacific after taxes were $15-million on a gross of $133,400,000. (That is railway operating income.) Those of Southern Pacific were $34,100,000 on a gross of $225-million. In other words, Southern Pacific showed up quite a bit better in net than it did in gross; it had a better than two to one ratio as against Northern Pacific.

In the first eight months of 1946 the net earnings of Northern Pacific before income taxes and depreciation, were $27,700,000, or pretty nearly 20 per cent of its gross; and those of Southern Pacific were only $29,500,000, which was just about nine per cent of its gross. Although Southern Pacific showed a very considerable improvement in its gross earnings as against Northern Pacific, its net earnings before taxes, depreciation charges, and interest charges were very much poorer proportionately. The explanation of that, as I said before, is found in the details of its transportation and maintenance expenditures, which apparently have grown very much more rapidly for Southern Pacific than they have for Northern Pacific-Burlington.

The question that was asked about the general future prospects of one territory as compared with another is certainly very relevant to analysis of railroad securities. Yet I must say that I have found in my own work that you can count very much more dependably upon differences of value which can be established from the earnings and expense picture than you can on those which seem to be inherent in the possibilities of the different territories.

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Those of you who are familiar with our textbook know that we recommend “the comparative balance sheet approach” for various reasons, one of which is to obtain a check on the reported earnings. In the war period just finished that is particularly important because the reported earnings have been affected by a number of abnormal influences, the true nature of which can be understood only by a study of balance sheet developments.

I have put on the blackboard a simple comparative example to illustrate this point. It is not particularly spectacular. It occurred to me because I observed that early this year Transue Williams and Buda Company both sold at the same high price, namely $33 1/2 a share; and in studying the companies’ record I could see that buyers could easily have been misled by the ordinary procedure of looking at the reported earnings per share as they appear, let us say, in Standard Statistics reports.

Now, as to procedure: First, the balance sheet comparison is a relatively simple idea. You take the equity for the stock at the end of the period, you subtract the equity at the beginning of the period, and the difference is the gain. That gain should be adjusted for items that do not relate to earnings, and there should be added back the dividends paid. Then you get the earnings for the period as shown by the balance sheet.

. In the case of Transue Williams the final stock equity was $2,979,000, of which $60,000 had come from the sale of stock, so that the adjusted equity would be $2,919,000. The indicated earnings were $430,000, or $3.17 a share. The transfer to a per share basis can be made at any convenient time that you wish. Dividends added back of $9.15 give you earnings per balance sheet of $12.32. But if you look at the figures that I have in the Standard Statistics reports, you would see that they add up to $14.73 for the ten years, so that the company actually lost $2.41 somewhere along the line.

The Buda situation is the opposite. We can take either the July 31, 1945 date or the July 31, 1946 date. It happens that only yesterday the July 31, 1946 figures came in, but it’s a little simpler to consider July, 1945 for this purpose. We find there that the equity increased $4,962,000 or $25.54 per share, the dividends were much less liberal — $4.20; indicated earnings per balance sheet, $29.74, but in the income account only $24.57. So this company did $5.17 better than it showed, if you assume that the reserves as given in the balance sheet are part of the stockholder’s equity and do not constitute a liability of the company.

If you ask the reason for the difference in the results in these two companies, you would find it, of course, in the treatment of the reserve items. The Transue & Williams Company reported earnings after allowances for reserves, chiefly for renegotiation, each year (reserves added up to $1,240,000 for 1942-45) and then almost every year they charged their actual payments on account of renegotiation to the reserves. It turned out that the amounts to be charged were greater than the amounts which they provided. The reserves set up by Transue and Williams, consequently, were necessary reserves for charges that they were going to have to meet; not only were they real, but they actually proved insufficient on the whole. I think I should perhaps correct what I said in this one respect: It may be that Transue and Williams called their reserve a reserve for contingencies, but actually it was a reserve for renegotiation which, as I said, proved insufficient.

. In the case of Buda you have the opposite situation. The Buda Company made very ample provision for renegotiation, which they charged to earnings currently, and in addition to that they set up reserves for contingencies. These apparently did not constitute in any sense real liabilities, because in July 1946 the reserves of a contingency nature remained at about a million dollars.

In the case of Transue, their reserves got up very high but the end of 1945 saw them down to $13,000, which indicated how necessary were the Transue reserves.

Now, let me pause for a moment to see if there is any question in your mind about this explanation as to why you get different earnings on the two bases, and why Buda shows larger earnings than reported and Transue shows smaller earnings that reported. Maybe a question will clarify it.

QUESTION: Does the equity include reserves?
MR. GRAHAM: Yes. That’s a good question. By equity we mean common stock plus surplus, plus whatever reserves are regarded as equivalent of surplus. Reserves which are for known liabilities or probable liabilities would, of course, not be part of the equity.
QUESTION: Might not depreciation charges, which make a great deal of difference in what your equity really was, not show up in there?
MR. GRAHAM: That is true. You can very well claim that certain charges for depreciation have created equities for stock which do not appear on the balance sheet, and I will go into that matter later. But that is a separate consideration from this item, in which we deal only with reserves for contingencies and the like. Are there other questions about that?
. Now, I have some other examples which I can go through very quickly to indicate more significant differences in the reported earnings, and the actual earnings. They would be found in some of the real “war babies”, particularly the aircraft manufacturing companies.

I mentioned last week the case of Curtiss-Wright, particularly because its price was statistically so low in relation to its performance in the past and also by comparison with another small company which I mentioned. Now, in the case of Curtiss-Wright, if you follow this procedure, you will find that on the balance sheet basis in ten years they apparently earned $18.53 per share but the reported earnings were only $12.28. In other words, an average of $1.22 is reported and $1.84 is shown by the balance sheet figures. That’s a very considerable difference, — an increase of 50 per cent. All of those extra earnings of $6.25 in ten years are to be found in the reserves set up during the last five years by the Curtiss Wright Corporation, none of which apparently are needed for specific war purposes, such as renegotiation payments or reconversion expenditures. Actually, the situation is quite the opposite in Curtiss Wright and others of that type. Instead of having to spend a great deal of money on plant in the reconversion period, you found the opposite has proved true. For in going over from war conditions to peace conditions these companies have turned a great deal of plant account into cash, which we will touch upon later.

In the United Aircraft situation you have somewhat the same picture, not as extreme. The reported earnings for ten years were $14.08 and the indicated earnings per balance sheet were $49.84, — a difference of about 20 per cent, or $8.77.

. If you look at the balance sheet there you will see that they have set up reserves amounting to $35-million or about $14 a share, and you may ask why the difference in earnings is not equal to the full reserves of $14 per share. Well, if you examine the report in detail you will see that part of those reserves were charged to earnings, and therefore served to decrease the reported earnings, but somewhat less than half, $15-million, was taken out of surplus and transferred to reserve. Restoration of this last amount, of course, would not serve to increase your reported earnings, because it was not deducted before arriving at the reported earnings. I hope you are all familiar with the difference between making a charge to reserves which would appear in the income account before your reported earnings, and a charge on the balance sheet only where it is transferred from surplus to reserves. The latter is purely internal, and a matter of no special significance.

These are the examples that I wanted to give you of comparative balance sheets for the purpose of determining what we might call true earnings, as compared with reported earnings.

*** . You remember in comparative Industrial Analysis we sometimes study the net earnings before taxes and depreciation. For the net before taxes is a useful item, and the deprecation may well be treated separately since it is partly arbitrary. Now I suggest we do the same thing for railroads and find out what that shows us. Well, here are figures for the Denver under 1945 and 1944. What we call the operating revenue or gross was 74.8 million in 1945 as against 70.3 million in 1944. Then first I’ll give you the result of a calculation which won’t appear in your income account, — namely, the single figure of net before income taxes and depreciation items. (That is not maintenance, of course; that’s depreciation, money for which cash has not been spent.) In 1944 this net was $23,220,000 and in 1945 it was $27,721,000. Hence the much poorer reported earnings for 1945 than in 1944 must be due to the fact that Denver charged off more in 1945 for taxes and depreciation. What are the figures? Depreciation, et cetera — and that includes an unusual item in Denver called “deferred maintenance,” not a large amount — was $16-million this year, against $6-million the year before. There’s $10-million of difference, approximately. Next we have income taxes, and this is really a first-class surprise. You would assume that if Denver charged $16-million for depreciation — and that’s mainly amortization of emergency facilities — that they would have shown a great benefit in their income taxes. Yet for 1945 they were able to work out an income tax bill of $10,576,000, whereas the year before it was only $5,338,000. Thus in 1945 both depreciation and income taxes were far greater than in 1944.

Now, you will raise two questions, of course. One is, did they really do better in 1945 than in 1944? And if they did, how was it possible for them to appear to have done so very much worse? The depreciation items you can understand readily. All the railroads charged off the full amortization of emergency facilities in 1945, and therefore the charges were higher in 1945 than in 1944. I am not too sure why they all did it, because it seems to me that in some cases they may not have needed that amortization for income tax purposes; and if so, it might have been better for them to have carried it along. But apparently they all decided to make the full charge-off.

. But the main problem is, how can they have paid so much for income taxes when their earnings were apparently so bad? After all, we never heard of a company which had a deficit of $7-million and had to pay $10-million of income taxes. The company’s report explains it to you in a rather incomplete way. The first important item is that $7,406,000 of this 1945 tax represents possible tax deficiencies for previous years. Obviously this item has nothing at all to do with the current year’s operations. We may hope that there are not really such deficiencies for the past year, but whatever they are they belong to the past years’ operations. Also, the depreciation charge of $16-million included $5,300,000 applicable to past years, and consequently the 1945 taxes did not get the benefit of that item, because that was carried back to past years in some rather complicated way. The net of the situation in the 1945 operations include $9-million of amortization and taxes which are applicable to previous years’ operations. If these were eliminated, instead of having a loss of $7-million for the year’s operations after interest taxes, they would have had a profit of $1,800,000. I can follow that explanation up to one point which isn’t clear. The taxes that they calculate as belonging to 1945 still amount to $6,900,000 that they would have to pay. But if their net earnings after taxes were really $1,800,000, this 1945 tax should have been about $1,100,000. So there is still a difference of $5,600,000 not accounted for.

One thing is quite clear now, to get back to the nub of the situation: These items are semi-manipulative, you might say. They have very little to do with the actual operating results of the Denver. Hence if you want to use the 1945 results in an evaluation of the system’s earning power, you obviously must give your primary attention to the $27,700,000 earned before taxes and depreciation, as compared with the $23,440,000 in 1944.

In 1946, of course, the Denver is not doing well. Very few roads are doing well. But the Denver is managing to earn money now against losses previously, but they are charging no income tax this year whereas last year they charged this enormous amount.

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Lecture Number One
May I welcome you all to this series of lectures. The large enrollment is quite a compliment to the Institute, and perhaps to the lecturer; but it also poses something of a problem. We shall not be able to handle this course on an informal or round-table basis. However, I should like to welcome as much discussion and as many intelligent questions as we can get, but I shall have to reserve the right to cut short discussion or not to answer questions in the interest of getting along with the course. You all understand our problem, I am sure.

I hope you will find that your time and money will be profitably spent in this course; but I want to add that the purpose of this course is to provide illustrative examples and discussions only, and not to supply practical ideas for security market operations. We assume no responsibility for anything said along the latter lines in this course; and so far as our own business is concerned we may or we may not have an interest in any of the securities that are mentioned and discussed. That is also a teaching problem with which we have been familiar through the years, and we want to get it behind us as soon as we can.

The subject of this course is “Current Problems in Security Analysis”, and that covers a pretty wide field. Actually, the idea is to attempt to bring our textbook “Security Analysis” up to date, in the light of the experience of the last six years since the 1940 revision was published.

The subject matter of security analysis can be divided in various ways. One division might be in three parts: First, the techniques of security analysis; secondly, standards of safety and common stock valuation; and thirdly, the relationship of the analyst to the security market.

Another way of dividing the subject might be to consider, first, the analyst as an investigator, in which role he gathers together all the relevant facts and serves them up in the most palatable and illuminating fashion he can. And then to consider the analyst as a judge of values, or an evaluator. This first division of the subject is rather useful, I think, because there is a good field in Wall Street for people whose work it will be mainly to digest the facts, and to abstain from passing judgment on the facts, leaving that to other people.

Such sticking to the facts alone might be very salutary; for the judgment of security analysts on securities is so much influenced by market conditions down here that most of us are not able, I fear, to express valuation judgments as good analysts. We find ourselves almost always acting as a mixture of market experts and security experts. I had hoped that there would be some improvement in that situation over the years, but I must confess that I haven’t seen a great deal of it. Analysts have recently been acting in Wall Street pretty much as they always have, that is to say, with one eye on the balance sheet and income account, and the other eye on the stock ticker. It might be best in this introductory lecture to deal with the third aspect of the security analyst’s work, and that is his relationship to the security market. It is a little more interesting, perhaps, than the other subdivisions, and I think it is relevant as introductory material.

The correct attitude of the security analyst toward the stock market might well be that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely. That is pretty much the position that most of us find ourselves vis-à-vis the stock market.

When we consider how the stock market has acted in the last six years, we shall conclude that it has acted pretty much as one would expect it to, based upon past experience. To begin with, it has gone up and it has gone down, and different securities have acted in different fashion. We have tried to illustrate this simply, by indicating on the blackboard the behavior of some sample stocks since the end of 1938. Let me take occasion to point out some of the features in this record that may interest security analysts.

There are two elements of basic importance, I think, that the analyst should recognize in the behavior of stocks over the last six years. The first is the principle of continuity, and the other is what I would call the principle of deceptive selectivity in the stock market.

First, with regard to continuity: The extraordinary thing about the securities market, if you judge it over a long period of years, is the fact that it does not go off on tangents permanently, but it remains in continuous orbit. When I say that it doesn’t go off on tangents, I mean the simple point that after the stock market goes up a great deal it not only comes down a great deal but it comes down to levels to which we had previously been accustomed. Thus we have never found the stock market as a whole going off into new areas and staying there permanently because there has been a permanent change in the basic conditions. I think you would have expected such new departures in stock prices. For the last thirty years, the period of time that I have watched the securities market, we have had two world wars; we have had a tremendous boom and a tremendous deflation; we now have the Atomic Age on us. Thus you might well assume that the security market could really have been permanently transformed at one time or another, so that the past records might not have been very useful in judging future values.

These remarks are relevant, of course, to developments since 1940. When the security market advanced in the last few years to levels which were not unexampled but which were high in relation to past experience, there was a general tendency for security analysts to assume that a new level of values had been established for stock prices which was quite different from those we had previously been accustomed to. It may very well be that individual stocks as a whole are worth more than they used to be. But the thing that doesn’t seem to be true is that they are worth so much more than they used to be that past experience — i.e., past levels and patterns of behavior — can be discarded.

One way of expressing the principle of continuity in concrete terms would be as follows: When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down — that is obvious — but it goes down to levels substantially below earlier high levels. Hence it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move. That means, in short, that the investor who says he does not wish to buy securities at high levels, because they don’t appeal to him on a historical basis or on an analytical basis, can point to past experience to warrant the assumption that he will have an opportunity to buy them at lower prices — not only lower than current high prices, but lower than previous high levels. In sum, therefore, you can take previous high levels, if you wish, as a measure of the danger point in the stock market for investors, and I think you will find that past experience would bear you out using this as a practical guide. Thus, if you look at this chart of the Dow Jones Industrial Average, you can see there has never been a time in which the price level has broken out, in a once-for-all or permanent way, from its past area of fluctuations. That is the thing I have been trying to point out in the last few minutes.

Another way of illustrating the principle of continuity is by looking at the long-term earnings of the Dow-Jones Industrial Average. We have figures here running back to 1915, which is more than thirty years, and it is extraordinary to see the persistence with which the earnings of the Dow-Jones Industrial Average return to a figure of about $10 per unit. It is true that they got away from it repeatedly. In 1917, for example, they got up to $22 a unit; but in 1921 they earned nothing. And a few years later they were back to $10. In 1915 the earnings of the unit were $10.59; in 1945 they were practically the same. All of the changes in between appear to have been merely of fluctuations around the central figure. So much for this idea of continuity?

The second thing that I want to talk about is selectivity. Here is an idea that has misled security analysts and advisers to a very great extent. In the few weeks preceding the recent break in the stock market I noticed that a great many of the brokerage house advisers were saying that now that the market has ceased to go up continuously, the thing to do is to exercise selectivity in your purchases; and in that way you can still derive benefits from security price changes. Well, it stands to reason that if you define selectivity as picking out a stock which is going to go up a good deal later on — or more than the rest — you are going to benefit. But that is too obvious a definition. What the commentators mean, as is evident from their actual arguments, is that if you buy the securities which apparently have good earnings prospects, you will then benefit market-wise; whereas if you buy the others you won’t.

History shows this to be a very plausible idea but an extremely misleading one; that is why I referred to this concept of selectivity as deceptive. One of the easiest ways to illustrate that is by taking two securities here in the Dow-Jones Average, National Distillers and United Aircraft. You will find that National Distillers sold at lower average prices in 1940-1942 than in 1935-1939. No doubt there was a general feeling that the company’s prospects were not good, primarily because it was thought that war would not be a very good thing for a luxury type of business such as whiskey is politely considered to be.

In the same way you will find that the United Aircraft Company through 1940-1942, was better regarded than the average stock, because it was thought that here was a company that had especially good prospects of making money; and so it did. But if you had bought and sold these securities, as most people seem to have done, on the basis of these obvious differential prospects, you would have made a complete error. For, as you see, National Distillers went up from the low of 1940 more than fivefold recently, and is now selling nearly four times its 1940 price. The buyer of United Aircraft would have had a very small profit at its best price and would now have a loss of one third of his money.

This principle of selectivity can be explored in various other ways.

*** Now my point in going at these two things in such detail is to try to bring home to you the fact that what seems to be obvious and simple to the people in Wall Street, as well as to their customers, is not really obvious and simple at all. You are not going to get good results in security analysis by doing the simple, obvious thing of picking out the companies that apparently have good prospects — whether it be the automobile industry, or the building industry, or any such combination of companies which almost everybody can tell you are going to enjoy good business for a number of years to come. That method is just too simple and too obvious — and the main fact about it is that it does not work well. The method of selectivity which I believe does work well is one that is based on demonstrated value differentials representing the application of security analysis techniques which have been well established and well tested. These techniques frequently yield indications that a security is undervalued, or at least that it is definitely more attractive than other securities may be, with which it is compared.

As an example of that kind of thing, I might take the comparisons that were made in the Security Analysis*, 1940 edition, between three groups of common stocks. They were compared as of the end of 1938, or just before the war. Of these groups one contained common stocks said to be speculative because their price was high; the second contained those said to be speculative because of their irregular record; and the third contained those said to be attractive investments because they met investment tests from a quantitative standpoint. Let me now mention the names of the stocks, and indicate briefly what is their position as of today. Group A consisted of * “Security Analysis” by Graham & Dodd.

General Electric, Coca-Cola, and Johns-Manville. Their combined price at the end of 1938 was $281, and at recent lows it was $?03.50 which meant that they have advanced eight per cent. The second group (about which we expressed no real opinion except that they could not be analyzed very well) sold in the aggregate for 124 at the end of 1938 and at recent lows for 150, which was an advance of 20 per cent.

The three stocks which were said to be attractive investments from the quantitative standpoint sold at 70 1/2 at the end of 1938 — that is for one share of each — and their value at the recent lows was 207, or an increase of 190 per cent.

Of course, these performances may be just a coincidence. You can’t prove a principle by one or two examples. But I think it is a reasonably good illustration of the results which you should get on the average by using investment tests of merit, as distinct from the emphasis on general prospects which plays so great a part in most of the analysis that I see around the Street.

*** I want to pass on finally to the most vulnerable position of the securities market in the recent rise, and that is the area of new common stock offerings. The aggregate amount of these offerings has not been very large in hundreds of millions of dollars, because the typical company involved was comparatively small. But I think the effect of these offerings upon the position of people in Wall Street was quite significant, because all of these offerings were bought by people who, I am quite sure, didn’t know what they were doing and were thus subject to very sudden changes of heart and attitude with regard to their investments. If you made any really careful study of the typical offerings that we have seen in the last twelve months you will agree, I am sure, with a statement made (only in a footnote unfortunately) by the Securities and Exchange Commission on August 20, 1946. They say that: “The rapidity with which many new securities, whose evident hazards are plainly stated in a registration statement and prospectus, are gobbled up at prices far exceeding any reasonable likelihood of return gives ample evidence that the prevalent demand for securities includes a marked element of blind recklessness. Registration cannot cure that.”

That is true. Among the astonishing things is the fact that the poorer the security the higher relatively was the price it was sold at. The reason is that most of the sounder securities had already been sold to and held by the public, and their market price was based on ordinary actions of buyers and sellers. The market price of the new securities has been largely determined, I think, by the fact that security salesmen could sell any security at any price; and there was therefore a tendency for the prices to be higher for these new securities than for others of better quality. I think it is worthwhile giving you a little resumé of one of the most recent prospectuses, which is summarized in the Standard Corporation Record of September 13, about a week ago. I don’t think this stock was actually sold, but it was intended to be sold at $16 a share. The name of the company is the Northern Engraving and Manufacturing Company, and we have this simple set-up: There are 250,000 shares to be outstanding, some of which are to be sold at $16 for the account of stockholders. That meant that this company was to be valued at $4-million in the market.

Now, what did the new stockholder get for his share of the $4-million? In the first place, he got $1,350,000 worth of tangible equity. Hence he was paying three times the amount of money invested in the business. In the second place, he got earnings which can be summarized rather quickly. For the five years 1936-40, they averaged 21cents a share; for the five years ended 1945, they averaged 65 cents a share. In other words, the stock was being sold at about 25 times the prewar earnings. But naturally there must have been some factor that made such a thing possible, and we find it in the six months ending June 30, 1946, when the company earned $1.27 a share. In the usual parlance of Wall Street, it could be said that the stock was being sold at six and a half times its earnings, the point being the earnings are at the annual rate of $2.54, and $16 is six or seven times that much.

It is bad enough, of course, to offer to the public anything on the basis of a six months’ earnings figure alone, when all the other figures make the price appear so extraordinarily high. But in this case it seems to me the situation is extraordinary in another respect — that it is in relation to the nature of the business. The company manufactures metal nameplates, dials, watch-dials, panels, etc. The products are made only against purchase contracts and are used by manufacturers of motors, controls, and equipment, and so forth.

Now, we don’t stress industrial analysis particularly in our course in security analysis, and I am not going to stress it here. But we have to assume that the security analyst has a certain amount of business sense. Surely he would ask himself, “how much profit can a company make in this line of business — operating on purchase contracts with automobile and other manufacturers — in relation both to its invested capital and its sales?”

In the six months ended June 1946 the company earned 15 per cent on its sales after taxes. It had previously tended to earn somewhere around three or four per cent on sales after taxes. It seems to me anyone would know that these earnings for the six months arose from the fact that any product could be sold provided only it could be turned out, and that extremely high profits could be realized in this kind of market. I think it would have been evident that under more sound conditions this is the kind of business which is doomed to earn a small profit margin on its sales and only a moderate amount on its net worth, for it has nothing particular to offer except the know-how to turn out relatively small gadgets for customer buyers.

That, I believe, illustrates quite well what the public had been offered in this recent new security market. There are countless other illustrations that I could give. I would like to mention one that is worth referring to, I think, because of its contrast with other situations.

The Taylorcraft Company is a maker of small airplanes. In June, 1946, they sold 20,000 shares of stock to the public at $13, the company getting one dollar; and then they voted a four-for-one split up. The stock is now quoted around two and a half or two and three quarters, the equivalent of about $11 for the stock that was sold.

If you look at the Taylorcraft Company, you find some rather extraordinary things in its picture. To begin with, the company is today selling for about $3-million, and this is supposedly in a rather weak market. The working capital shown as of June 30, 1946, is only $103,000. It is able to show even that much working capital, first, after including the proceeds of the sale of this stock, and secondly, after not showing as a current liability an excess profits tax of $196,000 which they are trying to avoid by means of a “Section 722” claim. Well, practically every corporation that I know of has filed Section 722 claims to try to cut down their excess profits taxes. This is the only corporation I know of that, on the strength of filing that claim, does not show its excess profits tax as a current liability.

They also show advances payable, due over one year, of $130,000, which of course don’t have to be shown as current liabilities. Finally, the company shows $2,300,000 for stock and surplus, which is not as much as the market price of the stock. But even here we note that the plant was marked up by $1,150,000, so that just about half of the stock and surplus is represented by what I would call an arbitrary plant mark-up.

Now, there are several other interesting things about the Taylorcraft Company itself, and there are still other things even more interesting when you compare it with other aircraft companies. For one thing, the Taylorcraft Company did not publish reports for a while and it evidently was not in too comfortable a financial position. Thus it arranged to sell these shares of stock in an amount which did not require registration with the SEC. But it is also a most extraordinary thing for a company in bad financial condition to arrange to sell stock to tide it over, and at the same time to arrange to split up its stock four for one. That kind of operation — to split a stock from $11 to three dollars — seems to me to be going pretty far in the direction of trading on the most unintelligent elements in Wall Street stock purchasing that you can find.

But the really astonishing thing is to take Taylorcraft and compare it, let us say, with another company like Curtiss-Wright. Before the split-up, Taylorcraft and Curtiss-Wright apparently were selling about the same price, but that doesn’t mean very much. The Curtiss-Wright Company is similar to United Aircraft in that its price is now considerably lower than its 1939 average. The latter was eight and three quarters, and its recent price was five and three quarters. In the meantime, the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130-million, approximately. It turns out that this company is selling in the market for considerably less than two thirds of its working capital.

The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous. So you have exactly the opposite situation in those two types of companies.

The contrast that I am giving you illustrates to my mind not only the obvious abuses of the securities market in the last two years, but it also illustrates the fact that the security analyst can in many cases come to pretty definite conclusions that one security is relatively unattractive and other securities are attractive. I think the same situation exists in today’s market as has existed in security markets always, namely, that there are great and demonstrable discrepancies in value — not in the majority of cases, but in enough cases to make this work interesting for the security analyst.

When I mentioned Curtiss-Wright selling at two thirds or less of its working capital alone, my mind goes back again to the last war; and I think this might be a good point more or less to close on, because it gives you an idea of the continuity of the security markets.

During the last war, when you were just beginning with airplanes, the Wright Aeronautical Company was the chief factor in that business, and it did pretty well in its small way, earning quite a bit of money. In 1922 nobody seemed to have any confidence in the future of the Wright Aeronautical Company. Some of you will remember our reference to it in Security Analysis. That stock sold then at eight dollars a share, when its working capital was about $18 a share at the time. Presumably “the market” felt that its prospects were very unattractive. That stock subsequently, as you may know, advanced to $280 a share.

Now it is interesting to see Curtiss-Wright again, after World War II, being regarded as presumably a completely unattractive company. For it is selling again at only a small percentage of its asset value, in spite of the fact that it has earned a great deal of money. I am not predicting that Curtiss-Wright will advance in the next ten years the way Wright Aeronautical did after 1922. The odds are very much against it. Because, if I remember my figures, Wright Aeronautical had only about 250,000 shares in 1922 and Curtiss-Wright has about 7,250,000 shares, which is a matter of great importance. But it is interesting to see how unpopular companies can become, merely because their immediate prospects are clouded in the speculative mind.

I want to say one other thing about the Curtiss-Wright picture, which leads us over into the field of techniques of analysis, about which I intend to speak at the next session. When you study the earnings of Curtiss-Wright in the last ten years, you will find that the earnings shown year by year are quite good; but the true earnings have been substantially higher still, because of the fact that large reserves were charged off against these earnings which have finally appeared in the form of current assets in the balance sheet. That point is one of great importance in the present-day technique of analysis.

In analyzing a company’s showing over the war period it is quite important that you should do it by the balance sheet method, or at least use the balance sheet as a check. That is to say, subtract the balance sheet value shown at the beginning from that at the end of the period, and add back the dividends. This sum — adjusted for capital transactions — will give you the earnings that were actually realized by the company over the period. In the case of Curtiss-Wright we have as much as $44-million difference between the earnings as shown by the single reports and the earnings as shown by a comparison of surplus and reserves at the beginning and end of the period. These excess or unraveled earnings alone are more than six dollars a share on the stock, which is selling today at only about that figure.

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This one is hard to believe…

So, here is the application\ to get a couple hundred bucks a week for food stamps here in Massachusetts. You’ll notice it is 9 pages.

Here is the application for banks to get billions of dollars from the US Government……..um….6 pages

I just don’t even know where to go with this one…..

Just me but I think I would prefer a little more scrutiny of Citi (C), Bank of America (BAC), Merril Lynch (MER), Goldman Sachs (GS), American Express (AXP) and the others than has pissed away near a trillion dollars now than some guy in a housing project trying to scam some extra food stamps to pay for his Marlboro’s and beer…..but that’s just me..

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This is one of the better Rogers interviews I have seen

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Can’t do much worse than last year…

1- Oil again reaches in excess of $100 a barrel from the $40 it sits at today

2- The US dollar nose dives in value another 30%

3- Gold soars past $1100 an ounce and stays there for much of the year

4- 2009 GDP growth is negative for the year

5- Steve Jobs leaves Apple for health reasons

6- Illinois Gov. Rod Blagojevich takes someone in President Obama’s administration down with him…media ignores it..calls the offender “a renegade staffer” and praises the new administration for not knowing what its staffers are doing.

7- Israel takes military action against Iran (see oil and gold predictions)

8- An anti-trust suit is brought against Google

9- Dow 6/1 7500, 12/31 8300….

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To review. Here were the 8 picks for ’08: Final results, call it a 1.5 out of 8…

1- Sherwin Williams (SHW) gets a bid from a potential buyer

Not yet……although I still think in 2009 this will happen…

2- The US WILL NOT slip into recession

We do not know for sure if we technically will have until sometime in January (2 consecutive Q’s of negative GDP growth). I think one would have to be foolishly optimistic to think we avoided it though.

3- Citigroup (C) does not cut its dividend and does not break it self up.

ERRR. Citi cut it dividend on Jan 15th and again in October.  I did not , however, break itself up…although it should…

4- Google (GOOG) purchases Sprint (S)..

This is great…..

– Yet another reason to ignore him…

– And another

– And another

– And another

We could do this forever…..

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Wealth of Nations- Adam Smith 1776

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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