The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [173]
Since the potential gain on a stock is unlimited, while no loss can exceed 100%, the only person you will enrich with this strategy is your broker. You’ve put a floor under your losses, but you’ve also slapped a ceiling over your gains. For individual investors, covering your downside is never worth surrendering most of your upside.
Chapter 17
Four Extremely Instructive Case Histories
The word “extremely” in the title is a kind of pun, because the histories represent extremes of various sorts that were manifest on Wall Street in recent years. They hold instruction, and grave warnings, for everyone who has a serious connection with the world of stocks and bonds—not only for ordinary investors and speculators but for professionals, security analysts, fund managers, trust-account administrators, and even for bankers who lend money to corporations. The four companies to be reviewed, and the different extremes that they illustrate are:
Penn Central (Railroad) Co. An extreme example of the neglect of the most elementary warning signals of financial weakness, by all those who had bonds or shares of this system under their supervision. A crazily high market price for the stock of a tottering giant.
Ling-Temco-Vought Inc. An extreme example of quick and unsound “empire building,” with ultimate collapse practically guaranteed; but helped by indiscriminate bank lending.
NVF Corp. An extreme example of one corporate acquisition, in which a small company absorbed another seven times its size, incurring a huge debt and employing some startling accounting devices.
AAA Enterprises. An extreme example of public stock-financing of a small company; its value based on the magic word “franchising,” and little else, sponsored by important stock-exchange houses. Bankruptcy followed within two years of the stock sale and the doubling of the initial inflated price in the heedless stock market.
The Penn Central Case
This is the country’s largest railroad in assets and gross revenues. Its bankruptcy in 1970 shocked the financial world. It has defaulted on most of its bond issues, and has been in danger of abandoning its operations entirely. Its security issues fell drastically in price, the common stock collapsing from a high level of 86½ as recently as 1968 to a low of 5½ in 1970. (There seems little doubt that these shares will be wiped out in reorganization.)*
Our basic point is that the application of the simplest rules of security analysis and the simplest standards of sound investment would have revealed the fundamental weakness of the Penn Central system long before its bankruptcy—certainly in 1968, when the shares were selling at their post-1929 record, and when most of its bond issues could have been exchanged at even prices for well-secured public-utility obligations with the same coupon rates. The following comments are in order:
1. In the S & P Bond Guide the interest charges of the system are shown to have been earned 1.91 times in 1967 and 1.98 times in 1968. The minimum coverage prescribed for railroad bonds in our textbook Security Analysis is 5 times before income taxes and 2.9 times after income taxes at regular rates. As far as we know the validity of these standards has never been questioned by any investment authority. On the basis of our requirements for earnings after taxes, the Penn Central fell short of the requirements for safety. But our after-tax requirement is based on a before-tax ratio of five times, with regular income tax deducted after the bond interest. In the case of Penn Central, it had been paying no income taxes to speak of for the past 11 years! Hence the coverage of its interest charges before taxes was less than two times—a totally inadequate figure against our conservative requirement of 5 times.
2. The fact that the company paid no income taxes over so long a period should have raised serious