A Comparison of Eight Pairs of Companies


CHAPTER 18

A Comparison of Eight Pairs of Companies

 In this chapter we shall attempt a novel form of exposition. By selecting eight pairs of companies which appear next to each other, or nearly so, on the stock-exchange list we hope to bring home in a concrete and vivid manner some of the many varieties of character, financial structure, policies, performance, and vicissitudes of corporate enterprises, and of the investment and speculative attitudes found on the financial scene in recent years. In each comparison we shall comment only on those aspects that have a special meaning and import.
Pair I: Real Estate Investment Trust (stores, offices, factories, etc.) and Realty Equities Corp. of New York (real estate investment; general construction)
   In this first comparison we depart from the alphabetical order used for the other pairs. It has a special significance for us, since it seems to encapsulate, on the one hand, all that has been reasonable, stable, and generally good in the traditional methods of handling other people’s money, in contrast—in the other company—with the reckless expansion, the financial legerdemain, and the roller-coaster changes so often found in present-day corporate operations. The two enterprises have similar names, and for many years they appeared side by side on the American Stock Exchange list. Their stock-ticker symbols—REI and REC—could easily have been confused. But one of them is a staid New England trust, administered by three trustees, with operations dating back nearly a century, and with dividends paid continuously since 1889. It has kept throughout to the same type of prudent investments, limiting 
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its expansion to a moderate rate and its debt to an easily manage-able figure. *
   The other is a typical New York-based sudden-growth venture, which in eight years blew up its assets from $6.2 million to $154 million, and its debts in the same proportion; which moved out from ordinary real-estate operations to a miscellany of ventures, including two racetracks, 74 movie theaters, three literary agencies, a public-relations firm, hotels, supermarkets, and a 26% interest in a large cosmetics firm (which went bankrupt in 1970).† This conglomeration of business ventures was matched by a corresponding variety of corporate devices, including the following: 

1.  A preferred stock entitled to $7 annual dividends,  but with a par value of only $1, and carried as         a  liability at $1 per share.
2.  A stated common-stock value of $2,500,000 ($1 per share), more than offset by a deduction of            $5,500,000 as the cost of 209,000 shares of reacquired stock.
3.  Three series of stock-option warrants, giving rights to buy a total of 1,578,000 shares.
4.  At least six different kinds of debt obligations, in the form of mortgages, debentures, publicly             held  notes, notes payable to banks, “notes, loans, and contracts payable,” and loans payable to          the   Small Business Administration, adding up to over $100 million in March 1969. In                          addition it had  the usual taxes and accounts payable.
   Let us present first a few figures of the two enterprises as they appeared in 1960 (Table 18-1A). Here we find the Trust shares selling in the market for nine times the aggregate value of Equities stock. The Trust enterprise had a smaller relative debt and a better

* Here Graham is describing Real Estate Investment Trust, which was acquired by San Francisco Real Estate Investors in 1983 for $50 a share. The next paragraph describes Realty Equities Corp. of New York.
† The actor Paul Newman was briefly a major shareholder in Realty Equities Corp. of New York after it bought his movie-production company, Kayos, Inc., in 1969.

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ratio of net to gross, but the price of the common was higher in relation to per-share earnings.
   In Table 18-1B we present the situation about eight years later. The Trust had “kept the noiseless tenor of its way,” increasing both its revenues and its per-share earnings by about three-quarters.* But Realty Equities had been metamorphosed into something monstrous and vulnerable.
   How did Wall Street react to these diverse developments? By paying as little attention as possible to the Trust and a lot to Realty Equities. In 1968 the latter shot up from 10 to 373⁄4 and the listed warrants from 6 to 361⁄2, on combined sales of 2,420,000 shares. While this was happening the Trust shares advanced sedately from 20 to 301⁄4 on modest volume. The March 1969 balance sheet of Equities was to show an asset value of only $3.41 per share, less than a tenth of its high price that year. The book value of the Trust shares was $20.85.

* Graham, an avid reader of poetry, is quoting Thomas Gray’s “Elegy Written in a Country Churchyard.”
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   The next year it became clear that all was not well in the Equities picture, and the price fell to 91⁄2. When the report for March 1970 appeared the shareholders must have felt shell-shocked as they read that the enterprise had sustained a net loss of $13,200,000, or $5.17 per share—virtually wiping out their former slim equity. (This disastrous figure included a reserve of $8,800,000 for future losses on investments.) Nonetheless the directors had bravely (?) declared an extra dividend of 5 cents right after the close of the fiscal year. But more trouble was in sight. The company’s auditors refused to certify the financial statements for 1969–70, and the shares were suspended from trading on the American Stock Exchange. In the over-the-counter market the bid price dropped below $2 per share.*
   Real Estate Investment Trust shares had typical price fluctuations after 1969. The low in 1970 was 161⁄2, with a recovery to 265⁄6 in early 1971. The latest reported earnings were $1.50 per share, and the stock was selling moderately above its 1970 book value of $21.60. The issue may have been somewhat overpriced at its record high in 1968, but the shareholders have been honestly and well served by their trustees. The Real Estate Equities story is a different and a sorry one.
Pair 2: Air Products and Chemicals (industrial and medicalgases, etc.) and Air Reduction Co. (industrial gases andequipment; chemicals)
   Even more than our first pair, these two resemble each other in both name and line of business. The comparison they invite is thus of the conventional type in security analysis, while most of our other pairs are more heteroclite in nature.† “Products” is a newer

* Realty Equities was delisted from the American Stock Exchange in September 1973. In 1974, the U.S. Securities and Exchange Commission sued Realty Equities’ accountants for fraud. Realty Equities’ founder, Morris Karp, later pleaded guilty to one count of grand larceny. In 1974–1975, the overindebtedness that Graham criticizes led to a financial crisis among large banks, including Chase Manhattan, that had lent heavily to the most aggressive realty trusts.
† “Heteroclite” is a technical term from classical Greek that Graham uses to mean abnormal or unusual.

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company than “Reduction,” and in 1969 had less than half the other’s volume.* Nonetheless its equity issues sold for 25% more in the aggregate than Air Reduction’s stock. As Table 18-2 shows, the reason can be found both in Air Reduction’s greater profitability and in its stronger growth record. We find here the typical consequences of a better showing of “quality.” Air Products sold at 161⁄2 times its latest earnings against only 9.1 times for Air Reduction. Also Air Products sold well above its asset backing, while Air Reduction could be bought at only 75% of its book value.† Air Reduction paid a more liberal dividend; but this may be deemed to reflect the greater desirability for Air Products to retain its earnings. Also, Air Reduction had a more comfortable working-capital position. (On this point we may remark that a profitable company can always put its current position in shape by some form of permanent financing. But by our standards Air Products was somewhat overbonded.)
   If the analyst were called on to choose between the two companies he would have no difficulty in concluding that the prospects of Air Products looked more promising than those of Air Reduction. But did this make Air Products more attractive at its considerably higher relative price? We doubt whether this question can be answered in a definitive fashion. In general Wall Street sets “quality” above “quantity” in its thinking, and probably the majority of security analysts would opt for the “better” but dearer Air Products as against the “poorer” but cheaper Air Reduction. Whether this preference is to prove right or wrong is more likely to depend on the unpredictable future than on any demonstrable investment principle. In this instance, Air Reduction appears to belong to the group of important companies in the low-multiplier class. If, as the studies referred to above†† would seem to indicate, that groupas a

* By “volume,” Graham is referring to sales or revenues—the total dollar amount of each company’s business.
† “Asset backing” and book value are synonyms. In Table 18-2, the relationship of price to asset or book value can be seen by dividing the first line (“Price, December 31, 1969”) by “Book value per share.”
†† Graham is citing his research on value stocks, which he discusses in Chapter 15 (see p. 389). Since Graham completed his studies, a vast body of scholarly work has confirmed that value stocks outperform (cont’d on p. 453)

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whole is likely to give a better account of itself than the high-multiplier stocks, then Air Reduction should logically be given the preference—but only as part of a diversified operation. (Also, a thorough-going study of the individual companies could lead the analyst to the opposite conclusion; but that would have to be for reasons beyond those already reflected in the past showing.) Sequel: Air Products stood up better than Air Reduction in the
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1970 break, with a decline of 16% against 24%. However, Reduction made a better comeback in early 1971, rising to 50% above its 1969 close, against 30% for Products. In this case the low-multiplier issue scored the advantage—for the time being, at least.*
Pair 3: American Home Products Co. (drugs, cosmetics,household products, candy) and American Hospital SupplyCo. (distributor and manufacturer of hospital supplies andequipment)
   These were two “billion-dollar good-will” companies at the end of 1969, representing different segments of the rapidly growing and immensely profitable “health industry.” We shall refer to them as Home and Hospital, respectively. Selected data on both are presented in Table 18-3. They had the following favorable points in common: excellent growth, with no setbacks since 1958 (i.e., 100% earnings stability); and strong financial condition. The growth rate of Hospital up to the end of 1969 was considerably higher than Home’s. On the other hand, Home enjoyed substantially better profitability on both sales and capital.† (In fact, the relatively low rate of Hospital’s earnings on its capital in 1969—only 9.7%—raises the intriguing question whether the business then was in fact a highly profitable one, despite its remarkable past growth rate in sales and earnings.)
   When comparative price is taken into account, Home offered

 (cont’d from p. 451) growth stocks over long periods. (Much of the best research in modern finance simply provides independent confirmation of what Graham demonstrated decades ago.) See, for instance, James L. Davis, Eugene F. Fama, and Kenneth R. French, “Characteristics, Covariances, and Average Returns: 1929–1997,” at http://papers.ssrn.com.
* Air Products and Chemicals, Inc., still exists as a publicly-traded stock and is included in the Standard & Poor’s 500-stock index. Air Reduction Co. became a wholly-owned subsidiary of The BOC Group (then known as British Oxygen) in 1978.
† You can determine profitability, as measured by return on sales and return on capital, by referring to the “Ratios” section of Table 18-3. “Net/sales” measures return on sales; “Earnings/book value” measures return on capital.

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much more for the money in terms of current (or past) earnings and dividends. The very low book value of Home illustrates a basic ambiguity or contradiction in common-stock analysis. On the one hand, it means that the company is earning a high return on its capital—which in general is a sign of strength and prosperity. On the other, it means that the investor at the current price would be especially vulnerable to any important adverse change in the company’s earnings situation. Since Hospital was selling at over four times its book value in 1969, this cautionary remark must be applied to both companies.
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   CONCLUSIONS: Our clear-cut view would be that both companies were too “rich” at their current prices to be considered by the investor who decides to follow our ideas of conservative selection. This does not mean that the companies were lacking in promise. The trouble is, rather, that their price contained too much “promise” and not enough actual performance. For the two enterprises combined, the 1969 price reflected almost $5 billion of good-will valuation. How many years of excellent future earnings would it take to “realize” that good-will factor in the form of dividends or tangible assets?
   SHORT-TERM SEQUEL: At the end of 1969 the market evidently thought more highly of the earnings prospects of Hospital than of Home, since it gave the former almost twice the multiplier of the latter. As it happened the favored issue showed a microscopic decline in earnings in 1970, while Home turned in a respectable 8% gain. The market price of Hospital reacted significantly to this one-year disappointment. It sold at 32 in February 1971—a loss of about 30% from its 1969 close—while Home was quoted slightly above its corresponding level.*
Pair 4: H & R Block, Inc. (income-tax service) and Blue Bell,Inc., (manufacturers of work clothes, uniforms, etc.)
    These companies rub shoulders as relative newcomers to the New York Stock Exchange, where they represent two very different genres of success stories. Blue Bell came up the hard way in a highly competitive industry, in which eventually it became the largest factor. Its earnings have fluctuated somewhat with industry conditions, but their growth since 1965 has been impressive. The company’s operations go back to 1916 and its continuous dividend record to 1923. At the end of 1969 the stock market showed no enthusiasm for the issue, giving it a price/earnings ratio of only 11, against about 17 for the S & P composite index. By contrast, the rise of H & R Block has been meteoric. Its first

* American Home Products Co. is now known as Wyeth; the stock is included in the Standard & Poor’s 500-stock index. American Hospital Supply Co. was acquired by Baxter Healthcare Corp. in 1985.


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published figures date only to 1961, in which year it earned $83,000 on revenues of $610,000. But eight years later, on our comparison date, its revenues had soared to $53.6 million and its net to $6.3 million. At that time the stock market’s attitude toward this fine performer appeared nothing less than ecstatic. The price of 55 at the close of 1969 was more than 100 times the last reported 12-months’ earnings—which of course were the largest to date. The aggregate market value of $300 million for the stock issue was nearly 30 times the tangible assets behind the shares.* This was almost unheard of in the annals of serious stock-market valuations. (At that time IBM was selling at about 9 times and Xerox at 11 times book value.)
   Our Table 18-4 sets forth in dollar figures and in ratios the extraordinary discrepancy in the comparative valuations of Block and Blue Bell. True, Block showed twice the profitability of Blue Bell per dollar of capital, and its percentage growth in earnings over the past five years (from practically nothing) was much higher. But as a stock enterprise Blue Bell was selling for less than one-third the total value of Block, although Blue Bell was doing four times as much business, earning 21⁄2 times as much for its stock, had 51⁄2 times as much in tangible investment, and gave nine times the dividend yield on the price.
   INDICATED CONCLUSIONS: An experienced analyst would have conceded great momentum to Block, implying excellent prospects for future growth. He might have had some qualms about the dangers of serious competition in the income-tax-service field, lured by the handsome return on capital realized by Block.1  But mindful of the continued success of such outstanding companies as Avon Products in highly competitive areas, he would have hesitated to predict a speedy flattening out of the Block growth curve. His chief

* “Nearly 30 times” is reflected in the entry of 2920% under “Price/book value” in the Ratios section of Table 18-4. Graham would have shaken his head in astonishment during late 1999 and early 2000, when many high-tech companies sold for hundreds of times their asset value (see the commentary on this chapter). Talk about “almost unheard of in the annals of serious stock-market valuations”! H & R Block remains a publicly-traded company, while Blue Bell was taken private in 1984 at $47.50 per share.

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concern would be simply whether the $300 million valuation for the company had not already fully valued and perhaps overvalued all that one could reasonably expect from this excellent business. By contrast the analyst should have had little difficulty in recommending Blue Bell as a fine company, quite conservatively priced.
   SEQUEL TO MARCH 1971. The 1970 near-panic lopped one-quarter off the price of Blue Bell and about one-third from that of Block. Both then joined in the extraordinary recovery of the general mar-
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ket. The price of Block rose to 75 in February 1971, but Blue Bell advanced considerably more—to the equivalent of 109 (after a three-for-two split). Clearly Blue Bell proved a better buy than Block as of the end of 1969. But the fact that Block was able to advance some 35% from that apparently inflated value indicates how wary analysts and investors must be to sell good companies short—either by word or deed—no matter how high the quotation may seem.*
Pair 5: International Flavors & Fragrances (flavors, etc., forother businesses) and International Harvester Co. (truckmanufacturer, farm machinery, construction machinery)

   This comparison should carry more than one surprise. Everyone knows of International Harvester, one of the 30 giants in the Dow Jones Industrial Average.† How many of our readers have even heard of International Flavors & Fragrances, next-door neighbor to Harvester on the New York Stock Exchange list? Yet, mirabile dictu, IFF was actually selling at the end of 1969 for a higher aggregate market value than Harvester—$747 million versus $710 million. This is the more amazing when one reflects that Harvester had 17 times the stock capital of Flavors and 27 times the annual sales. In

* Graham is alerting readers to a form of the “gambler’s fallacy,” in which investors believe that an overvalued stock must drop in price purely because it is overvalued. Just as a coin does not become more likely to turn up heads after landing on tails for nine times in a row, so an overvalued stock (or stock market!) can stay overvalued for a surprisingly long time. That makes short-selling, or betting that stocks will drop, too risky for mere mortals.
† International Harvester was the heir to McCormick Harvesting Machine Co., the manufacturer of the McCormick reaper that helped make the mid-western states the “breadbasket of the world.” But International Harvester fell on hard times in the 1970s and, in 1985, sold its farm-equipment business to Tenneco. After changing its name to Navistar, the remaining company was booted from the Dow in 1991 (although it remains a member of the S & P 500 index). International Flavors & Fragrances, also a constituent of the S & P 500, had a total stock-market value of $3 billion in early 2003, versus $1.6 billion for Navistar.

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fact, only three years before, the net earnings of Harvester had been larger than the 1969 sales of Flavors! How did these extraordinary disparities develop? The answer lies in the two magic words: profitability and growth. Flavors made a remarkable showing in both categories, while Harvester left everything to be desired.
   The story is told in Table 18-5. Here we find Flavors with a sensational profit of 14.3% of sales (before income tax the figure was 23%), compared with a mere 2.6% for Harvester. Similarly, Flavors
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had earned 19.7% on its stock capital against an inadequate 5.5% earned by Harvester. In five years the net earnings of Flavors had nearly doubled, while those of Harvester practically stood still. Between 1969 and 1959 the comparison makes similar reading. These differences in performance produced a typical stock-market divergence in valuation. Flavors sold in 1969 at 55 times its last reported earnings, and Harvester at only 10.7 times. Correspondingly, Flavors was valued at 10.4 times its book value, while Harvester was selling at a 41% discount from its net worth.
   COMMENT AND CONCLUSIONS: The first thing to remark is that the market success of Flavors was based entirely on the development of its central business, and involved none of the corporate wheel-ing and dealing, acquisition programs, top-heavy capitalization structures, and other familiar Wall Street practices of recent years. The company has stuck to its extremely profitable knitting, and that is virtually its whole story. The record of Harvester raises an entirely different set of questions, but these too have nothing to do with “high finance.” Why have so many great companies become relatively unprofitable even during many years of general prosperity? What is the advantage of doing more than $21⁄2 billion of business if the enterprise cannot earn enough to justify the shareholders’ investment? It is not for us to prescribe the solution of this problem. But we insist that not only management but the rank and file of shareholders should be conscious that the problem exists and that it calls for the best brains and the best efforts possible to deal with it.* From the standpoint of common-stock selection, neither issue would have met our standards of sound, reasonably attractive, and moderately priced investment. Flavors was a typical brilliantly successful but lavishly valued company;

* For more of Graham’s thoughts on shareholder activism, see the commentary on Chapter 19. In criticizing Harvester for its refusal to maximize shareholder value, Graham uncannily anticipated the behavior of the company’s future management. In 2001, a majority of shareholders voted to remove Navistar’s restrictions against outside takeover bids—but the board of directors simply refused to implement the shareholders’ wishes. It’s remarkable that an antidemocratic tendency in the culture of some companies can endure for decades.

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Harvester’s showing was too mediocre to make it really attractive even at its discount price. (Undoubtedly there were better values available in the reasonably priced class.)
    SEQUEL TO 1971: The low price of Harvester at the end of 1969 protected it from a large further decline in the bad break of 1970. It lost only 10% more. Flavors proved more vulnerable and declined to 45, a loss of 30%. In the subsequent recovery both advanced, well above their 1969 close, but Harvester soon fell back to the 25 level.
Pair 6: McGraw Edison (public utility and equipment;housewares) McGraw-Hill, Inc. (books, films, instructionsystems; magazine and newspaper publishers; informationservices)
   This pair with so similar names—which at times we shall call Edison and Hill—are two large and successful enterprises in vastly different fields. We have chosen December 31, 1968, as the date of our comparison, developed in Table 18-6. The issues were selling at about the same price, but because of Hill’s larger capitalization it was valued at about twice the total figure of the other. This difference should appear somewhat surprising, since Edison had about 50% higher sales and one-quarter larger net earnings. As a result, we find that the key ratio—the multiplier of earnings—was more than twice as great for Hill as for Edison. This phenomenon seems explicable chiefly by the persistence of a strong enthusiasm and partiality exhibited by the market toward shares of book-publishing companies, several of which had been introduced to public trading in the later 1960s.*
   Actually, by the end of 1968 it was evident that this enthusiasm had been overdone. The Hill shares had sold at 56 in 1967, more than 40 times the just-reported record earnings for 1966. But a small decline had appeared in 1967 and a further decline in 1968. Thus the current high multiplier of 35 was being applied to a company that

* McGraw-Hill remains a publicly-traded company that owns, among other operations, BusinessWeek magazine and Standard & Poor’s Corp. McGraw–Edison is now a division of Cooper Industries.

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had already shown two years of receding profits. Nonetheless the stock was still valued at more than eight times its tangible asset backing, indicating a good-will component of not far from a billion dollars! Thus the price seemed to illustrate—in Dr. Johnson’s famous phrase—“The triumph of hope over experience.”
   By contrast, McGraw Edison seemed quoted at a reasonable price in relation to the (high) general market level and to the company’s overall performance and financial position.
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   SEQUEL TO EARLY 1971: The decline of McGraw-Hill’s earnings continued through 1969 and 1970, dropping to $1.02 and then to $.82 per share. In the May 1970 debacle its price suffered a devastating break to 10—less than a fifth of the figure two years before. It had a good recovery thereafter, but the high of 24 in May 1971 was still only 60% of the 1968 closing price. McGraw Edison gave a better account of itself—declining to 22 in 1970 and recovering fully to 411⁄2 in May 1971.*
   McGraw-Hill continues to be a strong and prosperous company. But its price history exemplifies—as do so many other cases—the speculative hazards in such stocks created by Wall Street through its undisciplined waves of optimism and pessimism.
Pair 7: National General Corp. (a large conglomerate) andNational Presto Industries (diverse electric appliances,ordnance)
   These two companies invite comparison chiefly because they are so different. Let us call them “General” and “Presto.” We have selected the end of 1968 for our study, because the write-offs taken by General in 1969 made the figures for that year too ambiguous. The full flavor of General’s far-flung activities could not be savored the year before, but it was already conglomerate enough for anyone’s taste. The condensed description in theStock Guide read “Nation-wide theatre chain; motion picture and TV production, savings and loan assn., book publishing.” To which could be added, then or later, “insurance, investment banking, records, music publishing, computerized services, real estate—and 35% of Performance Systems Inc. (name recently changed from Minnie Pearl’s Chicken System Inc.).” Presto had also followed a diversification program, but in comparison with General it was modest indeed. Starting as the leading maker of pressure cookers, it had branched out into various other household and electric appliances. Quite differently, also, it took on a number of ordnance contracts for the U.S. government.

* In “the May 1970 debacle” that Graham refers to, the U.S. stock market lost 5.5%. From the end of March to the end of June 1970, the S & P 500 index lost 19% of its value, one of the worst three-month returns on record.

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   Our Table 18-7 summarizes the showing of the companies at the end of 1968. The capital structure of Presto was as simple as it could be—nothing but 1,478,000 shares of common stock, selling in the market for $58 million. Contrastingly, General had more than twice as many shares of common, plus an issue of convertible preferred, plus three issues of stock warrants calling for a huge amount of common, plus a towering convertible bond issue (just given in exchange for stock of an insurance company), plus a goodly sum of nonconvertible bonds. All this added up to a market capitalization of $534 million, not counting an impending issue of convertible bonds, and $750 million, including such issue. Despite National General’s enormously greater capitalization, it had actually done considerably less gross business than Presto in their fiscal years, and it had shown only 75% of Presto’s net income.
   The determination of the true market value of General’s common-stock capitalization presents an interesting problem for security analysts and has important implications for anyone interested in the stock on any basis more serious than outright gambling. The relatively small $41⁄2 convertible preferred can be readily taken care of by assuming its conversion into common, when the latter sells at a suitable market level. This we have done in Table 18-7. But the warrants require different treatment. In calculating the “full dilution” basis the company assumes exercise of all the warrants, and the application of the proceeds to the retirement of debt, plus use of the balance to buy in common at the market. These assumptions actually produced virtually no effect on the earnings per share in calendar 1968—which were reported as $1.51 both before and after allowance for dilution. We consider this treatment illogical and unrealistic. As we see it, the warrants represent a part of the “common-stock package” and their market value is part of the “effective market value” of the common-stock part of the capital. (See our discussion of this point on p. 415 above.) This simple technique of adding the market price of the warrants to that of the common has a radical effect on the showing of National General at the end of 1968, as appears from the calculation in Table 18-7. In fact the “true market price” of the common stock turns out to be more than twice the quoted figure. Hence the true multiplier of the 1968 earnings is more than doubled—to the inherently absurd figure of 69 times. The total market value of the “common-stock equivalents” then
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becomes $413 million, which is over three times the tangible assets shown therefor.
   These figures appear the more anomalous when comparison is made with those of Presto. One is moved to ask how could Presto possibly be valued at only 6.9 times its current earnings when the multiplier for General was nearly 10 times as great. All the ratios of Presto are quite satisfactory—the growth figure suspiciously so, in fact. By that we mean that the company was undoubtedly benefiting considerably from its war work, and the shareholders should be prepared for some falling off in profits under peacetime conditions. But, on balance, Presto met all the requirements of a sound and reasonably priced investment, while General had all the ear-marks of a typical “conglomerate” of the late 1960s vintage, full of corporate gadgets and grandiose gestures, but lacking in substantial values behind the market quotations.
   SEQUEL: General continued its diversification policy in 1969, with some increase in its debt. But it took a whopping write-off of millions, chiefly in the value of its investment in the Minnie Pearl Chicken deal. The final figures showed a loss of $72 million before tax credit and $46.4 million after tax credit. The price of the shares fell to 161⁄2 in 1969 and as low as 9 in 1970 (only 15% of its 1968 high of 60). Earnings for 1970 were reported as $2.33 per share diluted, and the price recovered to 281⁄2 in 1971. National Presto increased its per-share earnings somewhat in both 1969 and 1970, marking 10 years of uninterrupted growth of profits. Nonetheless its price declined to 211⁄2 in the 1970 debacle. This was an interesting figure, since it was less than four times the last reported earnings, and less than the net current assets available for the stock at the time. Late in 1971 we find the price of National Presto 60% higher, at 34, but the ratios are still startling. The enlarged working capital is still about equal to the current price, which in turn is only 51⁄2 times the last reported earnings. If the investor could now find ten such issues, for diversification, he could be confident of satisfactory results.*

* National Presto remains a publicly-traded company. National General was acquired in 1974 by another controversial conglomerate, American Financial Group, which at various times has had interests in cable television, banking, real estate, mutual funds, insurance, and bananas. AFG is also the final resting place of some of the assets of Penn Central Corp. (see Chapter 17).

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Pair 8: Whiting Corp. (materials-handling equipment) andWillcox & Gibbs (small conglomerate)
   This pair are close but not touching neighbors on the American Stock Exchange list. The comparison—set forth in Table 18-8A—makes one wonder if Wall Street is a rational institution. The company with smaller sales and earnings, and with half the tangible 



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assets for the common, sold at about four times the aggregate value of the other. The higher-valued company was about to report a large loss after special charges; it had not paid a dividend in thir-teen years. The other had a long record of satisfactory earnings, had paid continuous dividends since 1936, and was currently returning one of the highest dividend yields in the entire common-stock list. To indicate more vividly  the disparity in the performance of the two companies we append, in Table 18-8B, the earnings and price record for 1961–1970.
   The history of the two companies throws an interesting light on the development of medium-sized businesses in this country, in contrast with much larger-sized companies that have mainly appeared in these pages. Whiting was incorporated in 1896, and thus goes back at least 75 years. It seems to have kept pretty faith-fully to its materials-handling business and has done quite well with it over the decades. Willcox & Gibbs goes back even farther—to 1866—and was long known in its industry as a prominent maker
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of industrial sewing machines. During the past decade it adopted a policy of diversification in what seems a rather outlandish form. For on the one hand it has an extraordinarily large number of subsidiary companies (at least 24), making an astonishing variety of products, but on the other hand the entire conglomeration adds up to mighty small potatoes by usual Wall Street standards.
   The earnings developments in Whiting are rather characteristic of our business concerns. The figures show steady and rather spectacular growth from 41 cents a share in 1960 to $3.63 in 1968. But they carried no assurance that such growth must continue indefinitely. The subsequent decline to only $1.77 for the 12 months ended January 1971 may have reflected nothing more than the slowing down of the general economy. But the stock price reacted in severe fashion, falling about 60% from its 1968 high (431⁄2) to the close of 1969. Our analysis would indicate that the shares represented a sound and attractive secondary-issue investment—suitable for the enterprising investor as part of a group of such commitments.
   SEQUEL: Willcox & Gibbs showed a small operating loss for 1970. Its price declined drastically to a low of 41⁄2, recovering in typical fashion to 91⁄2 in February 1971. It would be hard to justify that price statistically. Whiting had a relatively small decline, to 163⁄4 in 1970. (At that price it was selling at just about the current assets alone available for the shares). Its earnings held at $1.85 per share to July 1971. In early 1971 the price advanced to 241⁄2, which seemed reasonable enough but no longer a “bargain” by our standards.*
General Observations
   The issues used in these comparisons were selected with some malice aforethought, and thus they cannot be said to present a random cross-section of the common-stock list. Also they are limited to the industrial section, and the important areas of public utilities,

* Whiting Corp. ended up a subsidiary of Wheelabrator-Frye, but was taken private in 1983. Willcox & Gibbs is now owned by Group Rexel, an electrical-equipment manufacturer that is a division of Pinault-Printemps-Redoute Group of France. Rexel’s shares trade on the Paris Stock Exchange.

A Comparison of Eight Pairs of Companies 470
transportation companies, and financial enterprises do not appear. But they vary sufficiently in size, lines of business, and qualitative and quantitative aspects to convey a fair idea of the choices confronting an investor in common stocks.
   The relationship between price and indicated value has also differed greatly from one case to another. For the most part the companies with better growth records and higher profitability have sold at higher multipliers of current earnings—which is logical enough in


A Comparison of Eight Pairs of Companies 471
general. Whether the specific differentials in price/earnings ratios are “justified” by the facts—or will be vindicated by future developments—cannot be answered with confidence. On the other hand we do have quite a few instances here in which a worthwhile judgment can be reached. These include virtually all the cases where there has been great market activity in companies of questionable underlying soundness. Such stocks not only were speculative— which means inherently risky—but a good deal of the time they were and are obviously overvalued. Other issues appeared to be worth more than their price, being affected by the opposite sort of market attitude—which we might call “underspeculation”—or by undue pessimism because of a shrinkage in earnings.
   In Table 18-9 we provide some data on the price fluctuations of the issues covered in this chapter. Most of them had large declines between 1961 and 1962, as well as from 1969 to 1970. Clearly the investor must be prepared for this type of adverse market movement in future stock markets. In Table 18-10 we show year-to-year


A Comparison of Eight Pairs of Companies 472
fluctuations of McGraw-Hill common stock for the period 1958–1970. It will be noted that in each of the last 13 years the price either advanced or declined over a range of at least three to two from one year to the next. (In the case of National General fluctuations of at least this amplitude both upward and downward were shown in each two-year period.)
   In studying the stock list for the material in this chapter, we were impressed once again by the wide difference between the  usual objectives of security analysis and those we deem dependable and rewarding. Most security analysts try to select the issues that will give the best account of themselves in the future, in terms chiefly of market action but considering also the development of earnings. We are frankly skeptical as to whether this can be done with satisfactory results. Our preference for the analyst’s work would be rather that he should seek the exceptional or minority cases in which he can form a reasonably confident judgment that the price is well below value. He should be able to do this work with sufficient expertness to produce satisfactory average results over the years.

COMMENTARY ON CHAPTER 18

The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun. Is there any thing whereof it may be said, See, this is new? it hath been already of old time, which was before us.
                                                                                                                  —Ecclesiastes, I: 9–10.

Let’s update Graham’s classic write-up of eight pairs of companies, using the same compare-and-contrast technique that he pioneered in his lectures at Columbia Business School and the New York Institute of Finance. Bear in mind that these summaries describe these stocks only at the times specified. The cheap stocks may later become overpriced; the expensive stocks may turn cheap. At some point in its life, almost every stock is a bargain; at another time, it will be expensive. Although there are good and bad companies, there is no such thing as a good stock; there are only good stock prices, which come and go.
P A I R   1 :   C I S C O   A N D   S Y S C O
On March 27, 2000, Cisco Systems, Inc., became the world’s most valuable corporation as its stock hit $548 billion in total value. Cisco, which makes equipment that directs data over the Internet, first sold its shares to the public only 10 years earlier. Had you bought Cisco’s stock in the initial offering and kept it, you would have earned a gain resembling a typographical error made by a madman: 103,697%, or a 217% average annual return. Over its previous four fiscal quarters, Cisco had generated $14.9 billion in revenues and $2.5 billion in earnings. The stock was trading at 219 times Cisco’s net income, one of the highest price/earnings ratios ever accorded to a large company.
    Then there was Sysco Corp., which supplies food to institutional 473
Commentary on Chapter 18- 474
kitchens and had been publicly traded for 30 years. Over its last four quarters, Sysco served up $17.7 billion in revenues—almost 20% more than Cisco—but “only” $457 million in net income. With a market value of $11.7 billion, Sysco’s shares traded at 26 times earnings, well below the market’s average P/E ratio of 31.
   A word-association game with a typical investor might have gone like this.
   Q: What are the first things that pop into your head when I say Cisco Systems?
   A: The Internet . . . the industry of the future . . . great stock . . . hot stock . . . Can I please buy some before it goes up even more?
   Q: And what about Sysco Corp.?
   A: Delivery trucks . . . succotash . . . Sloppy Joes . . . shepherd’s pie . . . school lunches . . . hospital food . . . no thanks, I’m not hungry anymore.
   It’s well established that people often assign a mental value to stocks based largely on the emotional imagery that companies evoke.1 But the intelligent investor always digs deeper. Here’s what a skeptical look at Cisco and Sysco’s financial statements would  have turned up:
•   Much of Cisco’s growth in revenues and earnings came from acquisitions. Since September alone,       Cisco had ponied up $10.2 billion to buy 11 other firms. How could so many companies be                  mashed together so quickly? 2 Also, roughly a third of Cisco’s
1 Ask yourself which company’s stock would be likely to rise more: one that discovered a cure for a rare cancer, or one that discovered a new way to dispose of a common kind of garbage. The cancer cure sounds more exciting to most investors, but a new way to get rid of trash would probably make more money. See Paul Slovic, Melissa Finucane, Ellen Peters, and Donald G. MacGregor, “The Affect Heuristic,” in Thomas Gilovich, Dale Griffin, and Daniel Kahneman, eds.,Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge University Press, New York, 2002), pp. 397–420, and Donald G. MacGregor, “Imagery and Financial Judgment,”The Journal of Psychology and Financial Markets, vol. 3, no. 1, 2002, pp. 15–22.
2 “Serial acquirers,” which grow largely by buying other companies, nearly always meet a bad end on Wall Street. See the commentary on Chapter 17 for a longer discussion.


Commentary on Chapter 18- 475
earnings over the previous six months came not from its businesses, but from tax breaks on stock options exercised by its executives and employees. And Cisco had gained $5.8 billion selling “investments,” then bought $6 billion more. Was it an Internet company or a mutual fund? What if those “investments” stopped going up?
•   Sysco had also acquired several companies over the same period—but paid only about $130 million. Stock options for Sysco’s insiders totaled only 1.5% of shares outstanding, versus 6.9% at Cisco. If insiders cashed their options, Sysco’s earnings per share would be diluted much less than Cisco’s. And Sysco had raised its quarterly dividend from nine cents a share to 10; Cisco paid no dividend.
   Finally, as Wharton finance professor Jeremy Siegel pointed out, no company as big as Cisco had ever been able to grow fast enough to justify a price/earnings ratio above 60—let alone a P/E ratio over 200.3 Once a company becomes a giant, its growth must slow down—or it will end up eating the entire world. The great American satirist Ambrose Bierce coined the word “incompossible” to describe two things that are conceivable separately but cannot exist together. A company can be a giant, or it can deserve a giant P/E ratio, but both together are incompossible.
   The wheels soon came off the Cisco juggernaut. First, in 2001, came a $1.2 billion charge to “restructure” some of those acquisitions. Over the next two years, $1.3 billion in losses on those “investments” leaked out. From 2000 through 2002, Cisco’s stock lost three-quarters of its value. Sysco, meanwhile, kept dishing out profits, and the stock gained 56% over the same period (see Figure 18-1).
P A I R   2 :   Y A H O O !   A N D   Y U M !
On November 30, 1999, Yahoo! Inc.’s stock closed at $212.75, up 79.6% since the year began. By December 7, the stock was at $348—
3 Jeremy Siegel, “Big-Cap Tech Stocks are a Sucker’s Bet,” Wall Street Journal, March 14, 2000 (available at www.jeremysiegel.com).


Commentary on Chapter 18- 476


a 63.6% gain in five trading days. Yahoo! kept whooping along through year-end, closing at $432.687 on December 31. In a single month, the stock had more than doubled, gaining roughly $58 billion to reach a total market value of $114 billion.4
    In the previous four quarters, Yahoo! had racked up $433 million in revenues and $34.9 million in net income. So Yahoo!’s stock was now priced at 263 times revenues and 3,264 times earnings. (Remember that a P/E ratio much above 25 made Graham grimace!)5
    Why was Yahoo! screaming upward? After the market closed on November 30, Standard & Poor’s announced that it would add Yahoo! to its S & P 500 index as of December 7. That would make Yahoo! a compulsory holding for index funds and other big investors—and that sudden rise in demand was sure to drive the stock even higher, at least temporarily. With some 90% of Yahoo!’s stock locked up in the hands of employees, venture-capital firms, and other restricted holders, just a fraction of its shares could trade. So thousands of people bought the stock only because they knew other people would have to buy it—and price was no object.
4 Yahoo!’s stock split two-for-one in February 2000; the share prices given here are not adjusted for that split in order to show the levels the stock actually traded at. But Yahoo!’s percentage return and market value, as cited here, do reflect the split.
5 Counting the effect of acquisitions, Yahoo!’s revenues were $464 million. Graham criticizes high P/E ratios in (among other places) Chapters 7 and 11.


Commentary on Chapter 18- 477
   Meanwhile, Yum! went begging. A former division of PepsiCo that runs thousands of Kentucky Fried Chicken, Pizza Hut, and Taco Bell eateries, Yum! had produced $8 billion in revenues over the previous four quarters, on which it earned $633 million—making it more than 17 times Yahoo!’s size. Yet Yum!’s stock-market value at year-end 1999 was only $5.9 billion, or 1/19 of Yahoo!’s capitalization. At that price, Yum!’s stock was selling at just over nine times its earnings and only 73% of its revenues.6
   As Graham liked to say, in the short run the market is a voting machine, but in the long run it is a weighing machine. Yahoo! won the short-term popularity contest. But in the end, it’s earnings that matter—and Yahoo! barely had any. Once the market stopped voting and started weighing, the scales tipped toward Yum! Its stock rose 25.4% from 2000 through 2002, while Yahoo!’s lost 92.4% cumulatively:


P A I R   3 :   C O M M E R C E   O N E   A N D   C A P I T A L   O N E
In May 2000, Commerce One, Inc., had been publicly traded only since the previous July. In its first annual report, the company (which 

6 Yum! was then known as Tricon Global Restaurants, Inc., although its ticker symbol was YUM. The company changed its name officially to Yum! Brands, Inc. in May 2002.


Commentary on Chapter 18- 478
designs Internet “exchanges” for corporate purchasing departments) showed assets of just $385 million and reported a net loss of $63 million on only $34 million in total revenues. The stock of this minuscule company had risen nearly 900% since its IPO, hitting a total market capitalization of $15 billion. Was it overpriced? “Yes, we have a big market cap,” Commerce One’s chief executive, Mark Hoffman, shrugged in an interview. “But we have a big market to play in. We’re seeing incredible demand. . . . Analysts expect us to make $140 million in revenue this year. And in the past we have exceeded expectations.”
Two things jump out from Hoffman’s answer:
•   Since Commerce One was already losing $2 on every dollar in sales, if it quadrupled its revenues         (as “analysts expect”), wouldn’t it lose money even more massively?
•   How could Commerce One have exceeded expectations “in the past”? What past?
   Asked whether his company would ever turn a profit, Hoffman was ready: “There is no question we can turn this into a profitable business. We plan on becoming profitable in the fourth quarter of 2001, a year analysts see us making over $250 million in revenues.”
   There come those analysts again! “I like Commerce One at these levels because it’s growing faster than Ariba [a close competitor whose stock was also trading at around 400 times revenues],” said Jeanette Sing, an analyst at the Wasserstein Perella investment bank. “If these growth rates continue, Commerce One will be trading at 60 to 70 times sales in 2001.” (In other words, I can name a stock that’s more overpriced than Commerce One, so Commerce One is cheap.)7
   At the other extreme was Capital One Financial Corp., an issuer of MasterCard and Visa credit cards. From July 1999, to May 2000, its stock lost 21.5%. Yet Capital One had $12 billion in total assets and earned $363 million in 1999, up 32% from the year before. With a market value of about $7.3 billion, the stock sold at 20 times Capital One’s net earnings. All might not be well at Capital One—the company had barely raised its reserves for loans that might go bad, even though 

7 See “CEO Speaks” and “The Bottom Line,” Money, May 2000, pp. 42–44.


Commentary on Chapter 18- 479
default rates tend to jump in a recession—but its stock price reflected at least some risk of potential trouble.
    What happened next? In 2001, Commerce One generated $409 million in revenues. Unfortunately, it ran a net loss of $2.6 billion—or $10.30 of red ink per share—on those revenues. Capital One, on the other hand, earned nearly $2 billion in net income in 2000 through 2002. Its stock lost 38% in those three years—no worse than the stock market as a whole. Commerce One, however, lost 99.7% of its value.8
   Instead of listening to Hoffman and his lapdog analysts, traders should have heeded the honest warning in Commerce One’s annual report for 1999: “We have never been profitable. We expect to incur net losses for the foreseeable future and we may never be profitable.”
P A I R   4 :   P A L M   A N D   3 C O M
  On March 2, 2000, the data-networking company 3Com Corp. sold 5% of its Palm, Inc. subsidiary to the public. The remaining 95% of Palm’s stock would be spun off to 3Com’s shareholders in the next few months; for each share of 3Com they held, investors would receive 1.525 shares of Palm.
    So there were two ways you could get 100 shares of Palm: By trying to elbow your way into the IPO, or by buying 66 shares of 3Com and waiting until the parent company distributed the rest of the Palm stock. Getting one-and-a-half shares of Palm for each 3Com share, you’d end up with 100 shares of the new company—and you’d still have 66 shares of 3Com.
   But who wanted to wait a few months? While 3Com was struggling against giant rivals like Cisco, Palm was a leader in the hot “space” of handheld digital organizers. So Palm’s stock shot up from its offering price of $38 to close at $95.06, a 150% first-day return. That valued Palm at more than 1,350 times its earnings over the previous 12 months.
   That same day, 3Com’s share price dropped from $104.13 to $81.81. Where should 3Com have closed that day, given the price of Palm? The arithmetic is easy:
8 In early 2003, Capital One’s chief financial officer resigned after securities regulators revealed that they might charge him with violations of laws against insider trading.


Commentary on Chapter 18- 480
•   each 3Com share was entitled to receive 1.525 shares of Palm
•   each share of Palm closed at $95.06
•   1.525 $95.06 = $144.97
   That’s what each 3Com share was worth based on its stake in Palm alone. Thus, at $81.81, traders were saying that all of 3Com’s other businesses combined were worth a negative $63.16 per share, or a total of minus $22 billion! Rarely in history has any stock been priced more stupidly.9
   But there was a catch: Just as 3Com wasn’t really worth minus $22 billion, Palm wasn’t really worth over 1,350 times earnings. By the end of 2002, both stocks were hurting in the high-tech recession, but it was Palm’s shareholders who really got smacked—because they abandoned all common sense when they bought in the first place:


Commentary on Chapter 18- 481
P A I R   5 :   C M G I   A N D   C G I
The year 2000 started off with a bang for CMGI, Inc., as the stock hit $163.22 on January 3—a gain of 1,126% over its price just one year before. The company, an “Internet incubator,” financed and acquired start-up firms in a variety of online businesses—among them such early stars as theglobe.com and Lycos.10
   In fiscal year 1998, as its stock rose from 98 cents to $8.52, CMGI spent $53.8 million acquiring whole or partial stakes in Internet companies. In fiscal year 1999, as its stock shot from $8.52 to $46.09, CMGI shelled out $104.7 million. And in the last five months of 1999, as its shares zoomed up to $138.44, CMGI spent $4.1 billion on acquisitions. Virtually all the “money” was CMGI’s own privately-minted currency: its common stock, now valued at a total of more than $40 billion.
   It was a kind of magical money merry-go-round. The higher CMGI’s own stock went, the more it could afford to buy. The more CMGI could afford to buy, the higher its stock went. First stocks would go up on the rumor that CMGI might buy them; then, once CMGI acquired them, its own stock would go up because it owned them. No one cared that CMGI had lost $127 million on its operations in the latest fiscal year.
   Down in Webster, Massachusetts, less than 70 miles southwest of CMGI’s headquarters in Andover, sits the main office of Commerce Group, Inc. CGI was everything CMGI was not: Offering automobile insurance, mainly to drivers in Massachusetts, it was a cold stock in an old industry. Its shares lost 23% in 1999—although its net income, at $89 million, ended up falling only 7% below 1998’s level. CGI even paid a dividend of more than 4% (CMGI paid none). With a total market value of $870 million, CGI stock was trading at less than 10 times what the company would earn for 1999.
   And then, quite suddenly, everything went into reverse. CMGI’s magical money merry-go-round screeched to a halt: Its dot-com

 10 CMGI began corporate life as College Marketing Group, which sold information about college professors and courses to academic publishers—a business that bore a faint but disturbing similarity to National Student Marketing, discussed by Graham on p. 235.


Commentary on Chapter 18- 482
stocks stopped rising in price, then went straight down. No longer able to sell them for a profit, CMGI had to take their loss in value as a hit to its earnings. The company lost $1.4 billion in 2000, $5.5 billion in 2001, and nearly $500 million more in 2002. Its stock went from $163.22 at the beginning of 2000 to 98 cents by year-end 2002—a loss of 99.4%. Boring old CGI, however, kept cranking out steady earnings, and its stock rose 8.5% in 2000, 43.6% in 2001, and 2.7% in 2002—a 60% cumulative gain.
P A I R   6 :   B A L L   A N D   S T R Y K E R
Between July 9 and July 23, 2002, Ball Corp.’s stock dropped from $43.69 to $33.48—a loss of 24% that left the company with a stockmarket value of $1.9 billion. Over the same two weeks, Stryker Corp.’s shares fell from $49.55 to $45.60, an 8% drop that left Strkyer valued at a total of $9 billion.
   What had made these two companies worth so much less in so short a time? Stryker, which manufactures orthopedic implants and surgical equipment, issued only one press release during those two weeks. On July 16, Stryker announced that its sales grew 15% to $734 million in the second quarter, while earnings jumped 31% to $86 million. The stock rose 7% the next day, then rolled right back downhill.
   Ball, the original maker of the famous “Ball Jars” used for canning fruits and vegetables, now makes metal and plastic packaging for industrial customers. Ball issued no press releases at all during those two weeks. On July 25, however, Ball reported that it had earned $50 million on sales of $1 billion in the second quarter—a 61% rise in net income over the same period one year earlier. That brought its earnings over the trailing four quarters to $152 million, so the stock was trading at just 12.5 times Ball’s earnings. And, with a book value of $1.1 billion, you could buy the stock for 1.7 times what the company’s tangible assets were worth. (Ball did, however, have just over $900 million in debt.)
   Stryker was in a different league. Over the last four quarters, the company had generated $301 million in net income. Stryker’s book value was $570 million. So the company was trading at fat multiples of 30 times its earnings over the past 12 months and nearly 16 times its book value. On the other hand, from 1992 through the end of 2001, Stryker’s earnings had risen 18.6% annually; its dividend had grown
Commentary on Chapter 18- 483
by nearly 21% per year. And in 2001, Stryker had spent $142 million on research and development to lay the groundwork for future growth.
   What, then, had pounded these two stocks down? Between July 9 and July 23, 2002, as WorldCom keeled over into bankruptcy, the Dow Jones Industrial Average fell from 9096.09 to 7702.34, a 15.3% plunge. The good news at Ball and Stryker got lost in the bad headlines and falling markets, which took these two stocks down with them.
   Although Ball ended up priced far more cheaply than Stryker, the lesson here is not that Ball was a steal and Stryker was a wild pitch. Instead, the intelligent investor should recognize that market panics can create great prices for good companies (like Ball) and good prices for great companies (like Stryker). Ball finished 2002 at $51.19 a share, up 53% from its July low; Stryker ended the year at $67.12, up 47%. Every once in a while, value and growth stocks alike go on sale. Which choice you prefer depends largely on your own personality, but bargains can be had on either side of the plate.
P A I R   7 :   N O R T E L   A N D   N O R T E K
The 1999 annual report for Nortel Networks, the fiber-optic equipment company, boasted that it was “a golden year financially.” As of February 2000, at a market value of more than $150 billion, Nortel’s stock traded at 87 times the earnings that Wall Street’s analysts estimated the company would produce in 2000.
   How credible was that estimate? Nortel’s accounts receivable—sales to customers that had not yet paid the bill—had shot up by $1 billion in a year. The company said the rise “was driven by increased sales in the fourth quarter of 1999.” However, inventories had also bal-looned by $1.2 billion—meaning that Nortel was producing equipment even faster than those “increased sales” could unload it.
   Meanwhile, Nortel’s “long-term receivables”—bills not yet paid for multi-year contracts—jumped from $519 million to $1.4 billion. And Nortel was having a hard time controlling costs; its  selling, general, and administrative expense (or overhead) had risen from 17.6% of revenues in 1997 to 18.7% in 1999. All told, Nortel had lost $351 million in 1999.
   Then there was Nortek, Inc., which produces stuff at the dim end of the glamour spectrum: vinyl siding, door chimes, exhaust fans, range hoods, trash compactors. In 1999, Nortek earned $49 million on $2 billion in net sales, up from $21 million in net income on $1.1 billion in sales in 1997. Nortek’s profit margin (net earnings as a percentage of
Commentary on Chapter 18- 484
net sales) had risen by almost a third from 1.9% to 2.5%. And Nortek had cut overhead from 19.3% of revenues to 18.1%.
   To be fair, much of Nortek’s expansion came from buying other companies, not from internal growth. What’s more, Nortek had $1 billion in debt, a big load for a small firm. But, in February 2000, Nortek’s stock price—roughly five times its earnings in 1999—included a healthy dose of pessimism.
   On the other hand, Nortel’s price—87 times the guesstimate of what it might earn in the year to come—was a massive overdose of optimism. When all was said and done, instead of earning the $1.30 per share that analysts had predicted, Nortel lost $1.17 per share in 2000. By the end of 2002, Nortel had bled more than $36 billion in red ink.
   Nortek, on the other hand, earned $41.6 million in 2000, $8 million in 2001, and $55 million in the first nine months of 2002. Its stock went from $28 a share to $45.75 by year-end 2002—a 63% gain. In January 2003, Nortek’s managers took the company private, buying all the stock from public investors at $46 per share. Nortel’s stock, meanwhile, sank from $56.81 in February 2000, to $1.61 at year-end 2002—a 97% loss.
P A I R   8 :   R E D   H A T   A N D   B R O W N   S H O E
On August 11, 1999, Red Hat, Inc., a developer of Linux software, sold stock to the public for the first time. Red Hat was red-hot; initially offered at $7, the shares opened for trading at $23 and closed at $26.031—a 272% gain.11 In a single day, Red Hat’s stock had gone up more than Brown Shoe’s had in the previous 18 years. By December 9, Red Hat’s shares hit $143.13—up 1,944% in four months.
   Brown Shoe, meanwhile, had its laces tied together. Founded in 1878, the company wholesales Buster Brown shoes and runs nearly 1,300 footwear stores in the United States and Canada. Brown Shoe’s stock, at $17.50 a share on August 11, stumbled down to $14.31 by December 9. For all of 1999, Brown Shoe’s shares lost 17.6%.12
11 All stock prices for Red Hat are adjusted for its two-for-one stock split in January 2000.
12 Ironically, 65 years earlier Graham had singled out Brown Shoe as one of the most stable companies on the New York Stock Exchange. See the 1934 edition of Security Analysis, p. 159.

Commentary on Chapter 18- 485
Besides a cool name and a hot stock, what did Red Hat’s investors get? Over the nine months ending November 30, the company produced $13 million in revenues, on which it ran a net loss of $9 million.13 Red Hat’s business was barely bigger than a street-corner delicatessen—and a lot less lucrative. But traders, inflamed by the words “software” and “Internet,” drove the total value of Red Hat’s shares to $21.3 billion by December 9.
   And Brown Shoe? Over the previous three quarters, the company had produced $1.2 billion in net sales and $32 million in earnings. Brown Shoe had nearly $5 a share in cash and real estate; kids were still buying Buster Brown shoes. Yet, that December 9, Brown Shoe’s stock had a total value of $261 million—barely  1/80 the size of Red Hat even though Brown Shoe had 100 times Red Hat’s revenues. At that price, Brown Shoe was valued at 7.6 times its annual earnings and less than one-quarter of its annual sales. Red Hat, on the other hand, had no profits at all, while its stock was selling at more than 1,000 times its annual sales.
    Red Hat the company kept right on gushing red ink. Soon enough, the stock did too. Brown Shoe, however, trudged out more profits—and so did its shareholders:


13 We use a nine-month period only because Red Hat’s 12-month results could not be determined from its financial statements without including the results of acquisitions.

Commentary on Chapter 18- 486
   What have we learned? The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end. If you buy a stock purely because its price has been going up—instead of asking whether the underlying company’s value is increasing—then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.
















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