18. A Comparison of Eight Pairs of Companies
The author means to use comparisons between companies that "appear next to each other, or nearly so, on the stock exchange list" to illustrate some of the significant differences among firms that make them appealing to investors or speculators.
(EN: There may seem to be no specific reason for pairing specific firms - but the author explains his rationale afterward.)
Real Estate Investment Tryst and Realty Equities Corporation
Aside of the alphabetical proximity of their ticker symbols, these two firms are both in the same industry, though REI invests in stores, offices, and factories and REC is more general real estate investment and construction.
REI is a "staid New England trust" that has made prudent investments and has paid continuous dividends since 1889, whereas REC is a "typical New York based sudden-growth venture" which "metamorphosed into something monstrous and venerable" but growing its assets from $6.2 million to $154 million over eight years and has invested in a myriad of ventures including race tracks, movie theaters, literary agencies, hotels, supermarkets, etc.
To finance these operations, REC has issued preferred stock that pay $7 annual dividends, but are carried as a liability of $1 per share; three series of stock-option warrants giving investors the right to purchase in excess of 1.5 million shares, and at least six kinds of debt obligations, from mortgages and debentures to some unusual forms of commercial paper.
In the estimation of Wall Street, REC has been favored while REI has been ignored. While the performance of REI has been stable and its financials sound, REC struggles under massive debt - having only ten cents on the dollar in assets to back the price of its shares, and trading at a rate of 162 times earnings.
This played out the following year, when REC suffered a loss of $5.17 per share in earnings (and its book value was only $3.41 per share), sending the stock plummeting from $32.50 to $9.50, then lower, ultimately to be delisted from the exchange and trading OTC for below $2 per share.
While REI has not been immune to fluctuations, the high book value per share kept these shifts moderate, and the company has been slowly and steadily generating a positive income and paying a reliable dividend.
Air Products and Chemicals and Air Reduction Co.
These two firms also resemble each other in both name and line of business, with APC dealing in industrial and medical gasses, and ARC dealing in industrial gasses and chemicals. APC is the younger of the firms, and has weaker profits and growth record, but was favored more by traders.
By comparison, APC's stock price was 39.5, 16.5 times earnings, had price to book of 165% and paid a dividend yield of 0.5%. ARC sold at 16.375, or 9.1 times earnings, price to book of 75% (less than the asset value of the shares) and paid a dividend of 4.9%.
Perhaps the only area in which APC outshone ARC was in its growth rate - 59% over five years and 362% over ten, whereas ARC grew 19% in five years and decreased in size over ten. This may be the logic by which speculators reckoned APC to be the greater value.
(EN: There is no epitaph for APC here, some remark that ARC made a better showing than APC in the following year, but the clear disparity between the firms shows that speculators can be wooed by a weak firm that is growing and abandon a strong firm that is not.)
American Home Products and American Hospital Supply
Both these firms are "billion dollar goodwill" companies, and both in the healthcare sector, though serving different market segments (consumers and hospitals).
Both firms had excellent growth and no setbacks for ten years, and relatively strong financial condition. The growth rate of Hospital was greater than Home, yet the latter enjoyed substantially better profitability.
In terms of stock price, both were wildly inflated, with Home trading at 31 times earnings with a price to book of 1250%, and Hospital trading at 58.5 times earnings with price to book a modest 575%.
The (more) extremely low book value of Home illustrates a basic ambiguity of stock analysis: it is a firm that is earning a high return on its capital, which is a general sign of strength and prosperity, but it also means that the investor who buys at the current price is especially vulnerable to the wiles of the market, the value of his holdings being largely based on the faith of the market. This is also true of Hospital, though to a lesser extent.
Both of these firms would be considered grossly overpriced by the author. While they are both promising firms, neither is so promising as to merit the price being offered for its stock.
The "short-term sequel" considers the following calendar year, where the prices of the firms moved in opposite directions of their profitability. Home turned a profit, though a lesser one than expected, and its shares dropped by 30%. Hospital took a "microscopic" decline in earnings, and fell only 8%.
H&R Block and Blue Bell Inc.
These two firms are both relative newcomers to the NYSE, but they represent very different paths to the market.
Blue Bell is a manufacture of work clothing and uniforms that had been un business since 1916. It received a lukewarm greeting by the market, and traded at a price/earnings ratio of only 11, compared to 17 for the overall market.
H&R Block, an income tax service, had a more meteoric rise and soared to more than 100 times earnings, the largest mark-up on a stock to the time, and entirely unheard of in the annals of serious stock valuations.
Block showed twice the profitability of Blue Bell, but as an enterprise, Bell was selling at a third the total value while doing four times as much business, earning 2.5 times as much per share, had 5.5 times as much in tangible investment, and offered nine times the dividend yield.
Experienced analysts would recognize that Block is an entirely capable and sound firm, but that its market price far exceeded its asset value and remained at a level at which it would be extremely different to maintain based on performance. It was simply not worth the price being asked for its shares.
In the following year, panic caused the price of Block to drop by a third, then to rally to 150% its original price. Meanwhile, the stock of Blue Bell nearly doubled in price that same year, yielding greater returns with significantly less risk to investors.
International Flavors & Fragrances and International Harvester
International Harvester, a manufacturer of farm and construction machinery, is familiar to many as one of the 30 giants in the DJIA. Meanwhile, few have heard of IFF, a creator of chemicals for the food and cosmetic industry - and yet, this firm sold for a higher aggregate value than the former titan.
This again seems to be a situation in which Wall Street favors a small but growing firm over an established form with steadier performance: Harvester earned 2.6 billion in revenues, sold at 10.7 times earnings and price-to-book of 59% on a ten-year growth of a respectable 39% - meanwhile Flavors earned about 94 million in revenues and was trading at 55 times earnings, had a price-to-book of 1050%, but had shown 326% growth during the same period.
Profitability is another factor: Flavors claimed a sensational profit of 14.3% that on revenues that were doubling every five years compared to Harvester's 2.6% profit on revenues that had not much changed over time.
In fairness, Flavors growth was entirely sensible: it had not engaged in the various methods of creative accounting that had been seen in other firms of the time, but merely grew its business at a highly aggressive rate without taking on considerably more debt. By all accounts, it was an excellent firm and a smashing success, but it had been valued in the market at an even more astronomical level. The author refers to the firm as being "brilliantly successful but lavishly valued."
McGraw Edison and McGraw Hill
These two firms are in vastly different industries - Edison in public utilities and Hill in publishing - but are interesting to compare because the shares of these two companies traded at nearly the same price on the last trading day of 1968.
The difference is that Edison had about 50% higher sales and 25% larger net earnings on a per-share basis. It traded at 15 times earnings (compared to Hill's 35) and at 180% of its book value (compared to 800%). The difference is even more curious in that Hill had shown two consecutive years of receding profits.
This further demonstrates the fickle nature of speculation, which came home to roost a few years later when, after two more years of declining profits, the firm took a serious tumble and share prices fell to almost half of their previous price, while Edison had increased by a respectable 10%.
Hill is not a particularly bad firm, and can in fairness be regarded as "strong and prosperous" - but the lesson of this case is that speculation creates waves lf optimism and pessimism about a firm, causing great fluctuations in its price, regardless of its financial strength and performance.
National General and National Presto
These two firms are diversified conglomerates: Presto had begun as a manufacturer of pressure cookers and household appliances, but had branched out into other fields of business, most notably the ordnance business in which it had significant government contracts. General was even more diverse, owning firms that included insurance, music and publishing, real estate, a movie studio, a book publisher, and banking.
A greater contrast can be seen in their capitalization: Presto's financing was simple - nothing but common stock. General, meanwhile, had more than twice as many shares of stock, plus convertible preferred stock, plus stock warrants, plus a "towering" convertible bond issue, plus "a goodly sum" of nonconvertible bonds.
As such, determining the true market value of General's common stock poses a perplexing problem, even for experienced security analysis with complete access to information about the firm's complicated financial situation.
Taking into account the level of the firm's debt and the potential for severe dilution by virtue of warrants and convertible issues, General's common stock were trading at the absurd level of 69 times earnings per share, and a book value of about 32% of its price - compared to Presto, which traded at a more reasonable 7 times earnings and a book value of closer to 70% of price.
Within a few years, General came unwound, writing off millions of dollars in investments, and its shares losing 85% of their value. Meanwhile, Presto's shares gained 60% in the marketing, but the price-to-earnings ratio remains startlingly low, such that the company remains attractive and promises satisfactory results.
A further epitaph was added some years later, when Presto remained a publicly traded company whereas General was acquired by another company, one that is infamous as "the final resting place" of the assets of bankrupted companies.
Whiting Corp and Willcox & Gibbs
This pair in particular leads the author to question whether "Wall street is a rational institution" in any regard.
Whiting, a materials-handling equipment manufacturer, is a small but steady firm with a long record of satisfactory earnings that has consistently paid dividends for over ten years. Its price is only 70% of its book value per share, and it trades at a respectable 9.3 times earnings.
Willcox, a conglomerate, has a market capitalization of four times as much as Whiting. Between erratic profitability and significantly higher debt, the firm has not paid a single dividend in the past ten years, its price is 470% of its book value, and it trades at the astronomical rate of nearly 194 times earnings.
Naturally, Willcox has experienced great swings in its price over time, between a high of $20.625 and a low of $3.75 - and has fluctuated between 5 and 12% within each calendar year. This pattern continued over the following years. In spite of its failure to fail completely, it remains a firm that the conservative investor would do well to avoid.
General Observations
The author concedes that the pairings for this chapter were selected "with some malice aforethought" and are not a completely random cross-section of the body of all common stocks. While the author avoided transportation companies, utilities, financial firms, and others whose capital structure is peculiar to their industrial sector, he did in fact choose for each pairing firms whose market value were significantly different to their financial performance, as a method of underscoring the value of considering the soundness of a firm, rather than its market price, in assessing the potential value and risk of investments.
For the most part, companies that show a better record of growth and higher profitability in the short term sell at much higher multipliers of current earnings and a price further removed from their book value than those who are not growing as quickly, but are financially sound and have been consistent over a longer period of time.
And this, particularly, indicates the nature of speculative risk: speculators who mean to make a profit in the short run turn to companies that perform well in the short run, regardless of their long-term potential. As a result, the price of stocks that appeal to this notion experience severe fluctuation, as the amount buyers are willing to pay is based on their hope of the future, regardless of the history of a firm or its present financial condition.
The long-term investor, who seeks stable and sound firms, will likely miss out on the peaks in the prices of securities, unless a long-staid firm suddenly comes into fashion with speculators. But he will also miss out on the valleys where speculators have abandoned such firms when their short-term performance is no longer to their liking, by whatever odd criteria on which their hope is based.