Four Extremely Instructive Case Histories
This is the seventeenth discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link).  In last week’s discussion, we discussed the sixteenth chapter, which explored some of Graham’s thoughts regarding convertible bonds.  This week we will discuss the seventeenth chapter, which is titled “Four Extremely Instructive Case Histories.”  I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor.  Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!
Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment.  We’ve had some great discussions throughout the book club, so keep it up!
ModernGraham’s Comments
Ben
Here, Graham looks at the histories of four different companies, all of which had proven to be bad investments which could have been avoided if investors had followed Graham’s teachings for Intelligent Investors. Â The four companies he reviewed in this chapter were Penn Central (Railroad) Company, Ling-Temco-Vought Inc., NVF Corp., and AAA Enterprises. Â All four took on very high levels of debt, through rapid expansion, acquisitions, etc. to the point where each company’s interest coverage level fell precipitously. Â Inevitably each company faced significant financial hurdles, leading to huge drops in stock price and/or bankruptcy.
This chapter in particular teaches valuable lessons about the effects of debt on a company’s long-term health.  In the ModernGraham approach, the level of debt is emphasized in both the Defensive Investor’s requirements (must have a current ratio greater than 2) and the Enterprising Investor’s requirements (must have a current ratio greater than 1.5 and the long-term debt must be less than 1.1 times the net current assets).  These requirements are specifically intended to help weed out companies which may present risks such as those seen in the companies from this chapter of The Intelligent Investor.  While it’s true that sometimes the requirements may eliminate some companies which don’t actually present concerning financial conditions, the screening does seem to consistently present only the companies presenting the least amount of risk due to debt levels.
Heather
If I could rename this chapter I would name it “Four stocks investors should avoid, but probably won’tâ€. My rationale for this name change is that Graham gives details on four scenarios that ended badly for investors, namely: neglecting financial warnings, serial acquirers, small companies absorbing big ones, and following the price set by the market, yet Zweig is able to identify four similar scenarios in the early 2000s. Clearly, investors hadn’t learned their lesson.
Perhaps not enough had read The Intelligent Investor, or those who did ignored Graham’s warning. Regardless of why other investors have kept buying bad companies, Graham gives us solid advice on what we, as value investors, can do to make sure that we don’t fall peril to the mistakes mentioned in this chapter. First, don’t be too willing to chalk up losses to “one bad year†or consider them non-recurring events. As Graham points out, many recurring events are categorized as non-recurring when clearly they are not one time events. They way companies account for their losses and gains can make them appear to be much better than they really are. That is why the ModernGraham model takes into account multiple statistics, making it easier to judge the true worth of a company. While it can be frustrating when all but one aspect of a company seems golden, ignoring the negative will not lead to good results.
Second, don’t jump on the bandwagon. If a stock is sky rocketing, you’re either too late to make the same gains as someone who bought early or you’re destined to lose everything when the stock crashes. This doesn’t mean you can’t invest in stock that has been rising due to good business practices and real gains, but it does mean you shouldn’t buy stock that is not worth its price such as with eToys.
Last, you need to care about the business model. Both Graham and Zweig note companies whose sole purpose was acquiring other companies, leading to debt and mismanagement. If the business model wouldn’t make sense for you to own as a sole proprietorship, it doesn’t make sense for you to buy as stock.
Discussion Questions
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- Do you think there are any exceptions to the rules that Graham mentions?
- What steps have you taken to ensure you don’t buy companies like the ones in the chapter?
- What did you think of the chapter overall?
Next Week’s Discussion: Chapter Eighteen
Chapter Title -Â A Comparison of Eight Pairs of Companies
When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.
What are some other ways to participate?
If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.
In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!
1. What quote from this chapter do you think best summarizes the point Graham is making? “Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.” Reality is, many of these analysts work for a firm with an agenda of making the firm money. Which is reasonable because that is what the employees are paid to do. The down side for us independent investors is that we can’t see the firm’s strategy behind the analysts’ publicly published reports. But one thing we can be sure, the firm’s strategy is for the firm’s profit. Dr. Graham, on the other hand, gave us an honest no nonsense way to make money and avoid the pitfalls of wall-street sales hype.
2. Do you think there are any exceptions to the rules that Graham mentions? The world of investing is full of exceptions to Graham’s recommendations. Most don’t consistently make money over the long haul. Facts are though that only God himself knows the future. Us mortals must hedge our bets to keep from experiencing undesirable outcomes with our nest eggs. For me Dr. Graham knows best, for others, they get to choose the methodology they will apply to investing.
3. What steps have you taken to ensure you don’t buy companies like the ones in the chapter? In addition to Graham’s defensive investor criteria – with some allowance for strong growth; I insist on a company having an above industry-average ROE and a low debt to equity ratio.
4. What did you think of the chapter overall? It was illustrative of what can happen when you buy story-stocks or hot-tip stocks, or chase growth without regard to the rest of the company’s fundamentals.
1) What quote from this chapter do you think best summarizes the point Graham is making?
“The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action†in progress. It will fall for any company identified with “franchising,†computers, electronics, science, technology, or what have you, when the particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness.â€
I am always amazed at companies that sell for hundreds and hundreds of multiples above earnings. That is simply a guess or a gamble, and it may never payout. There are tons of companies that you can choose without even thinking of buying into a company that costs so many times earnings. I can only think of the craziness that is Netflix. I did not want to touch it at $70 a share, and now that it is well above $400 a share I am speechless. Time will tell, but that is some crazy risk – unless you have inside information I suppose.
2) Do you think there are any exceptions to the rules that Graham mentions?
I strongly feel that Graham is a basic rule that applies to all securities you might purchase. I cannot see relaxing them unless you can find justification from significant research. That justification will be in the ideas that Graham mentioned in this book – bad news over a strong brand…
3) What steps have you taken to ensure you don’t buy companies like the ones in the chapter?
I follow Graham’s rules, and break down any securities I own at least 2 times a year to make sure they are still within the guidelines. I also follow any news that come from any company I own shares in. I try to review quarterly and yearly SEC filings right away.
4) What did you think of the chapter overall?
It is great to get real examples from Graham. I found this chapter to be very useful. It lets you know that you cannot always trust the companies financials, and the public can be blind.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“Moral: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.â€
2. Do you think there are any exceptions to the rules that Graham mentions?
As always, I think there are exceptions. But, I also think that following the rules mentioned by Graham and always keeping some kind of a skepticism when looking at different kinds of businesses should help investors stay away from the worst pitfalls.
3. What steps have you taken to ensure you don’t buy companies like the ones in the chapter?
As a general rule, I do not invest in IPOs. I read quarterly and annual reports (for a company and its competitors). I also look for businesses that have been able to show high returns on invested capital (or high returns on equity achieved with no or low use of leverage) over the last 5 to 10 years, with consistent generation of free cash flow. Also look for a margin of safety, i.e., a reasonable price compared to intrinsic value among other things. Besides the financial analysis and valuation part, I try to be as humble as possible and to recognize the danger of behavioral biases that affects the decisions to buy (and sell) a business.
4. What did you think of the chapter overall?
Enjoyed the chapter since I think it was an interesting read due to the case studies Graham discusses and applies his analytical framework to.
This post has also been published at http://hurricanecapital.wordpress.com.