The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [120]
In addition to the earnings-coverage test, a number of others are generally applied. These include the following:
1. Size of Enterprise. There is a minimum standard in terms of volume of business for a corporation—varying as between industrials, utilities, and railroads—and of population for a municipality.
2. Stock/Equity Ratio. This is the ratio of the market price of the junior stock issues* to the total face amount of the debt, or the debt plus preferred stock. It is a rough measure of the protection, or “cushion,” afforded by the presence of a junior investment that must first bear the brunt of unfavorable developments. This factor includes the market’s appraisal of the future prospects of the enterprise.
3. Property Value. The asset values, as shown on the balance sheet or as appraised, were formerly considered the chief security and protection for a bond issue. Experience has shown that in most cases safety resides in the earning power, and if this is deficient the assets lose most of their reputed value. Asset values, however, retain importance as a separate test of ample security for bonds and preferred stocks in three enterprise groups: public utilities (because rates may depend largely on the property investment), real-estate concerns, and investment companies.
At this point the alert investor should ask, “How dependable are tests of safety that are measured by past and present performance, in view of the fact that payment of interest and principal depends upon what the future will bring forth?” The answer can be founded only on experience. Investment history shows that bonds and preferred stocks that have met stringent tests of safety, based on the past, have in the great majority of cases been able to face the vicissitudes of the future successfully. This has been strikingly demonstrated in the major field of railroad bonds—a field that has been marked by a calamitous frequency of bankruptcies and serious losses. In nearly every case the roads that got into trouble had long been overbonded, had shown an inadequate coverage of fixed charges in periods of average prosperity, and would thus have been ruled out by investors who applied strict tests of safety. Conversely, practically every road that has met such tests has escaped financial embarrassment. Our premise was strikingly vindicated by the financial history of the numerous railroads reorganized in the 1940s and in 1950. All of these, with one exception, started their careers with fixed charges reduced to a point where the current coverage of fixed-interest requirements was ample, or at least respectable. The exception was the New Haven Railroad, which in its reorganization year, 1947, earned its new charges only about 1.1 times. In consequence, while all the other roads were able to come through rather difficult times with solvency unimpaired, the New Haven relapsed into trusteeship (for the third time) in 1961.
In Chapter 17 below we shall consider some aspects of the bankruptcy of the Penn Central Railroad, which shook the financial community in 1970. An elementary fact in this case was that the coverage of fixed charges did not meet conservative standards as early as 1965; hence a prudent bond investor would have avoided or disposed of the bond issues of the system long before its financial collapse.
Our observations on the adequacy of the past record to judge future safety apply, and to an even greater degree, to the public utilities, which constitute a major area for bond investment. Receivership of a soundly capitalized (electric) utility company or system is almost impossible. Since Securities and Exchange Commission control was instituted,* along with the breakup of most of the holding-company systems, public-utility financing has been sound and bankruptcies