The Intelligent Investor: The Definitive Book On Value part 35 pot

Benjamin Graham’s own book, The Interpretation of Financial Statements HarperBusiness, New York, 1998 reprint of 1937 edition, remains an excellent brief introduction to the basic princi

mal operating expenses into capital assets As the Global Crossing case shows, the intelligent investor should be sure to understand what, and why, a company capitalizes

A N I N V E N T O R Y S T O R Y

Like many makers of semiconductor chips, Micron Technology, Inc suffered a drop in sales after 2000 In fact, Micron was hit so hard by the plunge in demand that it had to start writing down the value of its inventories—since customers clearly did not want them at the prices Micron had been asking In the quarter ended May 2001, Micron slashed the recorded value of its inventories by $261 million Most investors interpreted the write-down not as a normal or recurring cost

of operations, but as an unusual event

But look what happened after that:

A Block of the Old Chips

261.1

465.8

172.8

3.8

25.9

173.6

90.8

0

50

100

150

200

250

300

350

400

450

500

May 2001 August 2001 November 2001 February 2002 May 2002 August 2002 November 2002

Micron Technology fiscal quarters

Source: Micron Technology’s financial reports.

FIGURE 12-1

Micron booked further inventory write-downs in every one of the next six fiscal quarters Was the devaluation of Micron’s inventory a nonrecurring event, or had it become a chronic condition? Reason-able minds can differ on this particular case, but one thing is clear: The intelligent investor must always be on guard for “nonrecurring” costs that, like the Energizer bunny, just keep on going.5

T H E P E N S I O N D I M E N S I O N

In 2001, SBC Communications, Inc., which owns interests in Cingular Wireless, PacTel, and Southern New England Telephone, earned $7.2 billion in net income—a stellar performance in a bad year for the overextended telecom industry But that gain didn’t come only from SBC’s business Fully $1.4 billion of it—13% of the company’s net income—came from SBC’s pension plan

Because SBC had more money in the pension plan than it esti-mated was necessary to pay its employees’ future benefits, the com-pany got to treat the difference as current income One simple reason for that surplus: In 2001, SBC raised the rate of return it expected to earn on the pension plan’s investments from 8.5% to 9.5%—lowering the amount of money it needed to set aside today

SBC explained its rosy new expectations by noting that “for each

of the three years ended 2001, our actual 10-year return on invest-ments exceeded 10%.” In other words, our past returns have been high, so let’s assume that our future returns will be too But that not only flunked the most rudimentary tests of logic, it flew in the face of the fact that interest rates were falling to near-record lows, depressing the future returns on the bond portion of a pension portfolio

The same year, in fact, Warren Buffett’s Berkshire Hathaway low-ered the expected rate of return on its pension assets from 8.3% to

6.5% Was SBC being realistic in assuming that its pension-fund man-agers could significantly outperform the world’s greatest investor? Probably not: In 2001, Berkshire Hathaway’s pension fund gained 9.8%, but SBC’s pension fund lost 6.9%.6

Research and Analysis for providing this example

the beginning of the year by “actual return on plan assets.”

Here are some quick considerations for the intelligent investor: Is the “net pension benefit” more than 5% of the company’s net income?

(If so, would you still be comfortable with the company’s other earn-ings if those pension gains went away in future years?) Is the assumed “long-term rate of return on plan assets” reasonable? (As of

2003, anything above 6.5% is implausible, while a rising rate is downright delusional.)

C A V E A T I N V E S T O R

A few pointers will help you avoid buying a stock that turns out to be

an accounting time bomb:

Read backwards When you research a company’s financial

reports, start reading on the last page and slowly work your way toward the front Anything that the company doesn’t want you to find

is buried in the back—which is precisely why you should look there first

Read the notes Never buy a stock without reading the footnotes

to the financial statements in the annual report Usually labeled “sum-mary of significant accounting policies,” one key note describes how the company recognizes revenue, records inventories, treats install-ment or contract sales, expenses its marketing costs, and accounts for the other major aspects of its business.7 In the other footnotes,

foot-notes They are designed expressly to deter normal people from actually reading them—which is why you must persevere A footnote to the 1996 annual report of Informix Corp., for instance, disclosed that “The Company generally recognizes license revenue from sales of software licenses upon delivery of the software product to a customer However, for certain com-puter hardware manufacturers and end-user licensees with amounts payable within twelve months, the Company will recognize revenue at the time the customer makes a contractual commitment for a minimum non-refundable license fee, if such computer hardware manufacturers and end-user licensees meet certain criteria established by the Company.” In plain English, Informix was saying that it would credit itself for revenues on prod-ucts even if they had not yet been resold to “end-users” (the actual cus-tomers for Informix’s software) Amid allegations by the U.S Securities and

watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other “risk factors” that can take a big chomp out of earnings Among the things that should make your antennae twitch are technical terms like “capitalized,” “deferred,” and

“restructuring”—and plain-English words signaling that the company has altered its accounting practices, like “began,” “change,” and “how-ever.” None of those words mean you should not buy the stock, but all mean that you need to investigate further Be sure to compare the footnotes with those in the financial statements of at least one firm that’s a close competitor, to see how aggressive your company’s accountants are

Read more If you are an enterprising investor willing to put plenty

of time and energy into your portfolio, then you owe it to yourself to learn more about financial reporting That’s the only way to minimize your odds of being misled by a shifty earnings statement Three solid books full of timely and specific examples are Martin Fridson and

Fer-nando Alvarez’s Financial Statement Analysis, Charles Mulford and Eugene Comiskey’s The Financial Numbers Game, and Howard Schilit’s Financial Shenanigans.8

Exchange Commission that Informix had committed accounting fraud, the company later restated its revenues, wiping away $244 million in such

“sales.” This case is a keen reminder of the importance of reading the fine print with a skeptical eye I am indebted to Martin Fridson for suggesting this example

Practitioner’s Guide (John Wiley & Sons, New York, 2002); Charles W

Mul-ford and Eugene E Comiskey, The Financial Numbers Game: Detecting

Creative Accounting Practices (John Wiley & Sons, New York, 2002);

Howard Schilit, Financial Shenanigans (McGraw-Hill, New York, 2002) Benjamin Graham’s own book, The Interpretation of Financial Statements

(HarperBusiness, New York, 1998 reprint of 1937 edition), remains an excellent brief introduction to the basic principles of earnings and expenses, assets and liabilities

A Comparison of Four Listed Companies

In this chapter we should like to present a sample of security analysis in operation We have selected, more or less at random, four companies which are found successively on the New York Stock Exchange list These are eltra Corp (a merger of Electric Autolite and Mergenthaler Linotype enterprises), Emerson Electric

Co (a manufacturer of electric and electronic products), Emery Air Freight (a domestic forwarder of air freight), and Emhart Corp (originally a maker of bottling machinery only, but now also in builders’ hardware).* There are some broad resemblances between the three manufacturing firms, but the differences will seem more significant There should be sufficient variety in the financial and operating data to make the examination of interest

In Table 13-1 we present a summary of what the four companies were selling for in the market at the end of 1970, and a few figures

on their 1970 operations We then detail certain key ratios, which

relate on the one hand to performance and on the other to price.

Comment is called for on how various aspects of the performance pattern agree with the relative price pattern Finally, we shall pass the four companies in review, suggesting some comparisons and relationships and evaluating each in terms of the requirements of a conservative common-stock investor

330

* Of Graham’s four examples, only Emerson Electric still exists in the same

Bunker Ramo Corp in the 1970s, putting it in the business of supplying stock quotes to brokerage firms across an early network of computers

formerly known as Emery Air Freight is now a division of CNF Inc Emhart Corp was acquired by Black & Decker Corp in 1989

3⁄4

3⁄4

The most striking fact about the four companies is that the current price/earnings ratios vary much more widely than their operating performance or financial condition Two of the enter-prises—eltra and Emhart—were modestly priced at only 9.7 times and 12 times the average earnings for 1968–1970, as against a similar figure of 15.5 times for the DJIA The other two—Emerson and Emery—showed very high multiples of 33 and 45 times such earnings There is bound to be some explanation of a difference such as this, and it is found in the superior growth of the favored companies’ profits in recent years, especially by the freight for-warder (But the growth figures of the other two firms were not unsatisfactory.)

For more comprehensive treatment let us review briefly the chief elements of performance as they appear from our figures

TABLE 13-2 A Comparison of Four Listed

Companies (continued)

Emerson Emery Emhart

B Ratios

Current assets to

Earnings growth per share:

C Price Record

1 Profitability (a) All the companies show satisfactory earnings

on their book value, but the figures for Emerson and Emery are much higher than for the other two A high rate of return on invested capital often goes along with a high annual growth rate in earnings per share.* All the companies except Emery showed bet-ter earnings on book value in 1969 than in 1961; but the Emery

fig-ure was exceptionally large in both years (b) For manufacturing

companies, the profit figure per dollar of sales is usually an indica-tion of comparative strength or weakness We use here the “ratio of

operating income to sales,” as given in Standard & Poor’s Listed Stock Reports Here again the results are satisfactory for all four

companies, with an especially impressive showing by Emerson The changes between 1961 and 1969 vary considerably among the companies

2 Stability This we measure by the maximum decline in

per-share earnings in any one of the past ten years, as against the aver-age of the three preceding years No decline translates into 100% stability, and this was registered by the two popular concerns But the shrinkages of eltra and Emhart were quite moderate in the

“poor year” 1970, amounting to only 8% each by our measurement, against 7% for the DJIA

3 Growth The two low-multiplier companies show quite

satis-factory growth rates, in both cases doing better than the Dow Jones group The eltra figures are especially impressive when set against its low price/earnings ratio The growth is of course more impressive for the high-multiplier pair

4 Financial Position The three manufacturing companies are in

sound financial condition, having better than the standard ratio of

$2 of current assets for $1 of current liabilities Emery Air Freight has a lower ratio; but it falls in a different category, and with its fine record it would have no problem raising needed cash All the com-panies have relatively low long-term debt “Dilution” note: Emer-son Electric had $163 million of market value of low-dividend

A Comparison of Four Listed Companies 333

* This measure is captured in the line “Net per share/book value” in Table 13-2, which measures the companies’ net income as a percentage of their tangible book value

convertible preferred shares outstanding at the end of 1970 In our analysis we have made allowance for the dilution factor in the usual way by treating the preferred as if converted into com-mon This decreased recent earnings by about 10 cents per share, or some 4%

5 Dividends What really counts is the history of continuance

without interruption The best record here is Emhart’s, which has not suspended a payment since 1902 eltra’s record is very good, Emerson’s quite satisfactory, Emery Freight is a newcomer The variations in payout percentage do not seem especially significant The current dividend yield is twice as high on the “cheap pair” as

on the “dear pair,” corresponding to the price/earnings ratios

6 Price History The reader should be impressed by the

percent-age advance shown in the price of all four of these issues, as mea-sured from the lowest to the highest points during the past 34 years (In all cases the low price has been adjusted for subsequent stock splits.) Note that for the DJIA the range from low to high was

on the order of 11 to 1; for our companies the spread has varied from “only” 17 to 1 for Emhart to no less than 528 to 1 for Emery Air Freight.* These manifold price advances are characteristic of most of our older common-stock issues, and they proclaim the great opportunities of profit that have existed in the stock markets

of the past (But they may indicate also how overdone were the declines in the bear markets before 1950 when the low prices were registered.) Both eltra and Emhart sustained price shrinkages of more than 50% in the 1969–70 price break Emerson and Emery had serious, but less distressing, declines; the former rebounded to a new all-time high before the end of 1970, the latter in early 1971

* In each case, Graham is referring to Section C of Table 13-2 and dividing the high price during the 1936–1968 period by the low price For example, Emery’s high price of 66 divided by its low price of 1/8 equals 528, or a ratio of 528 to 1 between the high and low

General Observations on the Four Companies

Emerson Electric has an enormous total market value, dwarfing

the other three companies combined.* It is one of our “good-will giants,” to be commented on later A financial analyst blessed (or handicapped) with a good memory will think of an analogy between Emerson Electric and Zenith Radio, and that would not be reassuring For Zenith had a brilliant growth record for many years; it too sold in the market for $1.7 billion (in 1966); but its prof-its fell from $43 million in 1968 to only half as much in 1970, and in that year’s big selloff its price declined to 221⁄2against the previous top of 89 High valuations entail high risks

Emery Air Freight must be the most promising of the four

compa-nies in terms of future growth, if the price/earnings ratio of nearly 40 times its highest reported earnings is to be even partially justified The past growth, of course, has been most impressive But these fig-ures may not be so significant for the future if we consider that they started quite small, at only $570,000 of net earnings in 1958 It often proves much more difficult to continue to grow at a high rate after volume and profits have already expanded to big totals The most surprising aspect of Emery’s story is that its earnings and market price continued to grow apace in 1970, which was the worst year in the domestic air-passenger industry This is a remarkable achieve-ment indeed, but it raises the question whether future profits may not be vulnerable to adverse developments, through increased com-petition, pressure for new arrangements between forwarders and air-lines, etc An elaborate study might be needed before a sound judgment could be passed on these points, but the conservative investor cannot leave them out of his general reckoning

Emhart and eltra Emhart has done better in its business than in

the stock market over the past 14 years In 1958 it sold as high as 22 times the current earnings—about the same ratio as for the DJIA Since then its profits tripled, as against a rise of less than 100% for the Dow, but its closing price in 1970 was only a third above the

A Comparison of Four Listed Companies 335

* At the end of 1970, Emerson’s $1.6 billion in market value truly was “enor-mous,” given average stock sizes at the time At year-end 2002, Emerson’s common stock had a total market value of approximately $21 billion