eco FieldConseco FieldhousePepsi CenterStaples CenterAdelphia ColiseumFedex FieldMellon ArenaGaylord Entertainment CenterComerica ParkEnron FieldXcel EnergyPNC ParkAmerican Airline Center
TGTDALAWAUALRKYFBFGMKEYTWACOMSCALERICYEIXQCOMATNETONEAMRSAFCCNCPEPSPLSADLACFDXMELGETCMAENEXELPNCAMR
1990199119921994199519951995199519951995199619961997199719971998199819981999199919991999199919991999199920002000200020012001
−3.5−7.7−86.0−38.6−2.0−8.2−8.610.9
−20.8−40.728.0−9.8−47.9−7.2−28.940.7
−4.2−43.3666.612.4−12.820.7−59.072.0
−27.3−48.51502.845.469.38.4−88.3−11.6
46.79.634.55.8−4.4−0.161.3−23.3−34.3−61.6−61.1−33.3−48.323.9−27.7−20.4−20.137.397.559.2−10.0−30.1
123.363.733.8−25.7−33.124.7−75.7−86.6−47.1−30.8−64.213.8−66.85.4−17.835.7−38.144.6−76.864.1
−75.8−45.645.9−66.63414.465.2−124.2−61.90.3−20.9−78.825.7−29.2−25.222.916.0−11.7
−93.8−34.5435.2−99.61507.620.8−45.0−39.2−40.7
Average
−4.75
−8.58
148.13
180.05
Median
−7.97
−19.29
−11.74
−27.27513.15
Standarddeviation
Source: www.ballparks.com.
158
39.86
50.47
695.60
% Up
33
39
44
41
# OB
30.00
28.00
25.00
17.00
Table 5.5 Paying the Piper for Serial Acquisitions: Purchases 1998–2001versus Performance January 1–July 12, 2002Company
Ticker
Purchases
PercentChange
15 most acquisitiveGeneral ElectricTycoClear Channel CommunicationsCitigroupAESAOL Time WarnerUnited TechnologiesGeneral MotorsAmerican International GroupMicrosoftWells FargoCisco SystemsFord MotorIntelJ.P. Morgan
GETYCCCUCAESAOLUTXGMAIGMSFTWFCCSCOFINTCJPM
663231281514141312121211111111
−28.6−76.7−33.9−28−79.6−59.1−2−4.1−20−21.7−13.6−62.4−19.8−40.2−16.9−33.8
Average % returnCompanies with 1 acquisitionBank of AmericaBlack & DeckerEMCHarrah’s EntertainmentInternational PaperMay Department StoresMedtronicMedimmune3MMerckOraclePfizerPharmaciaRadioShackSearsSBC CommunicationsThe Southern Co.
BACBDKEMCHETIPMAYMDTMEDIMMMMRKORCLPFEPHARSHSSBCSO
11111111111111111
−12.6
Average % returnCompanies with no acquisitionsAllegheny TechnologiesLtd BrandsAnheuser-Busch
913.9−36.419.11.5−18.2−24.5−47.72.3−22.5−29.9−19.2−23.6−11.1−2.4−24.3−0.2
ATILTDBUD
000
−14.111.48.8(continued)
159
160 Practical SpeculationTable 5.5 ContinuedCompany
Ticker
Avon ProductsBaker HughesBurlington Northern Santa FeCignaNorfolk SouthernCampbell SoupNortel NetworksColgate-PalmolivePhilip MorrisDelta Air LinesRaytheonFedExToys R UsGilletteXerox
AVPBHIBNICINSCCPBNTCLMODALRTNFDXTOYGXRX
Purchases000000000000000
PercentChange3−19.10.2−3.717.1−19.4−95.5−23.3−6.4−65.37.3−3.8−10.4−13.5−38.1
Average % return
−14.7
S&P 100
−21.5
with a modest preliminary study of the relation of acquisitions to stock performance.Taking the companies in the S&P 100 at the start of 1998, we counted thenumber of acquisitions each made over the next four years, through 2001. Wecame up with three groupings for comparison: the top 15 acquirers, companies that made no acquisitions, and companies that made one acquisition.We calculated their stock performance from January 1, 2002, through July 12,2002. The results appear in Table 5.5.As the table shows, serial acquirers underperformed abstainers by 19.1 percentage points, and they underperformed the S&P 100 by 12.8 percentagepoints. Abstainers beat the S&P 100 by 6.8 percentage points.The urge to merge can be good or bad, and each acquisition must bejudged on its merits. However, during the most recent four years, the urgehas been inversely related to year-to-date 2002 performance.From long experience on all vantage points of the acquisition arena—Vicfounded and for 25 years spearheaded a very active mergers-and-acquisitionbrokerage—we suggest that in certain types of markets, an acquisition mightoffer the temptation to overstate earnings. If the truth comes out, the stockmay be hammered.
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Making Mischief with the BooksWe have no knowledge of the accounting probity of any of the companies inthe news today. But we can say that, in general, most mischief begins with assets held on the books of acquired companies at original cost. If the acquiredcompany bought the assets many years before, or if the assets are worth muchmore than they cost (as must be assumed if they were bought at a premium),then there is great potential for an acquiring company to sell off these assetsat the market price for a nice profit.A second source of temptation is the potential boost to the acquiring company’s earnings from the acquisition. When a company’s stock is selling at 20times earnings and it buys something at 10 times earnings, there is an immediate pickup that can be calculated based on the number of shares and earnings involved.A third major line of misstatements is the prospect of writing certainitems up or down to advantage. The common practices of writing up goodwillfor tax purposes, or writing down pension obligations and medical plans ofthe acquired firms, are treasure chests in this regard.We emphasize that we have no reason to believe that serial acquirers areany more prone to such temptations than those that acquire less frequently.Multiple acquisitions are merely a possible signal, an area of concern in certain kinds of markets. Others, however, have come to similar conclusions. In aclassic 1986 study, “The Hubris Hypothesis of Corporate Takeovers,” RichardW. Roll found that acquiring companies often perform worse than the marketafter a deal, and that the motivation for the purchase thus could not rationallybe stock price appreciation. He posited that the main motivation would have tobe . . . hubris.29To assist our readers in evaluating acquisitions, we are pleased to presentinsights from a friend who is among the world’s leading experts in the subject: Vic’s partner of 35 years, Dan Grossman. Grossman has managed andbought a wide variety of businesses and, through his law practice, has been instrumental in forming and developing many companies, including the drugmaker Syntex. Dan recently sold a number of his businesses profitably and iswriting a book about his adventures in the M&A business.
Advice on Acquisitions from Dan Grossman• Avoid businesses requiring exquisite management. Buy a companythat regular people can run.
162 Practical Speculation• When evaluating an acquisition, picture what it will be like trying to sellit. Look for the type of business that buyers, especially public companies, will want to acquire.• Avoid mixing acquisition analysis with some other need in your life.Don’t look to acquire a company because it will get you involved withgolf or sailing, or because it is in a glamorous location, or because youhave been laid off and need a place to work. It is hard enough to be objective analyzing an acquisition on its own merits without throwing inall kinds of personal needs and desires.• Have a good accountant explain to you how inventory can be used tojuggle earnings, and why, for some companies, it is almost impossiblefor a buyer to determine the accuracy of reported earnings for a givenyear.• Time is the friend of a growth company and the enemy of the bargainor value company. The longer you are going to own, the more important to pay up for growth.The results of our preliminary study on acquisitions may unduly reflectthe unusual pessimism of the current stock market. Yet given the sad fates ofserial acquirers over the past few decades—the conglomerates, the rollups,and all the companies that became marquee names in the market value rankings by paying princely sums of their own soaring stock for tiny, unprofitablecompanies—it does not seem inappropriate to conclude that both acquirerand investor should be on guard when reaching for the stars.
Lords on BoardsThe hiring of celebrities as marketing tools is often associated with hubris inthe executive office. RJR Nabisco put golf pros on the payroll before beingbought by KKR (another act of hubris that brought on a long period of underperformance for the company). Kmart’s association with Martha Stewart,Kathy Ireland, and Jaclyn Smith did it no good. Even in bankruptcy, Kmartcontinued the same losing strategy, announcing in April 2002 that it had hiredthe Creative Artists Agency to get its name and products placed in movies.We tested this phenomenon systematically in September 2001 by studying the relation between stock returns and the number of board memberswith titles in the 50 largest companies by market value in Britain’s FTSE 100.(We counted knights, baronesses, earls, a viscount, a lady, and a dame, alongwith lords and right honorable lords. We awarded an extra point if the chairman was a lord.)
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We then listed the companies’ five-year stock performance, eliminatingthree that had not been around long enough in their present form. It turnsout that the more lords on board, the worse the stock performance over theprevious five years.Our observations on the relationship of lords and earnings raise the question of which way causality runs. Was it the lords who caused the lacklusterperformance or the lackluster performance that prompted the companies touse lords as window-dressing?HSBC Holdings, the fourth most valuable company in the FTSE 100, hadthe greatest number of lords—seven titled board members and a knightedchairman, Sir John Reginald Hartnell Bond.Eight of the 10 largest FTSE 100 companies had at least three lords. Thelargest, BP (formerly British Petroleum), has four lords. GlaxoSmithKline, thesecond largest, has six lords on board and a knighted chairman. About halfthe companies have between one and three lords. The largest company without lords was insurer CGNU, No. 13 on the FTSE.We also invented the earnings/lords (E/L) ratio—a measure of attractiveness along the lines of the price/earnings (P/E) ratio.A small or negative numerator (earnings) and a high denominator (lords)would result in a small or negative ratio. For example, HSBC made 75.5 centsa share last year and has eight lords on board. Therefore, it has an E/L ratio of0.09, putting it in the bottom third of the companies with both lords and profits. Powergen plc, with one lord and $1 of earnings per share, has it the highest E/L ratio. Cable & Wireless lost 93 cents a share last year, and has threelords on board; thus, its ratio is negative.We hypothesize that investors might want to stay away from companieswith small or negative earnings/lords ratios. However, our observations aremerely a first step toward defining the market implications of ossification versus innovation. Proper testing of this idea would require the analysis of several years of data unavailable in computer databases. In the spirit of science,we hope that our efforts will form the basis for further study.
Summing It All Up in Iambic PentameterAfter quantifying the market effects of executive boasting, flashy headquartersbuildings, magazine cover stories, stadium deals, and big acquisitions, we conclude that such instances of hubris can send a company’s stock plunging. Wesuspect that corporate golf courses (Lucent), opulent offices (RJR Nabisco),moves to Florida (Scott Paper), sex scandals (General Electric, Bendix), and
164 Practical Speculationexecutive pay exceeding $100 million a year (General Electric, Apple, SiebelSystems, Oracle, Cisco) might be profitable areas for future hubris tests.The Greeks believed that the stately and portentous language of iambicpentameter, which corresponds to the emotional heights of human speech,enhances the impact of tragedy. (An iamb is a weak syllable followed by astrong syllable, and iambic pentameter contains five weak-strongs to a line,with many artistic liberties taken.) We will therefore close with some heroicverses by Victor’s daughter, the producer and writer Galt Niederhoffer, whosecoming-of-age novel American Thighs is written in iambic pentameter:Hubris is on everybody’s mind of lateHumility seems like a memory.It seems that only yesterday thatEnron’s chairman, Kenneth LayDid boast of feats unmatched in a decade:“We’ve grown nine-fold to $40 billionAnd we’ll do it again before too long.”A messenger from the EconomistWas witness to his grandiosityReporting on the New EconomyHe found in Enron the epitome.So often history repeats itselfAnd so was Cisco twinning over timesReferring to its staunch predecessorsAs relics of the Old EconomyBehold, not more than 12 months ago,Cisco offered its own grand prophecyPredicting 30 percent to 50Though such growth occurs mainly in tragedySo diminished is the growth of tech firms nowThe media now calls them shriveled men.
6
BENJAMIN GRAHAM:MYTHICALMARKET HERO
When Benjamin Graham died at age 82, he was one of thegreat legends of Wall Street, brilliant, successful, ethical—theman who invented the discipline of security analysis. Now, 20years after his death his memoirs are reaching the public atlast—a hugely successful chronicle of one of the richest andmost eventful lives of the century.—Kirkus Review, June 9, 1996
T
he ancient Greeks had Hercules, the mighty hero deified by Zeus fornoble deeds and worshipped by men. In the twenty-first century, Americans have Benjamin Graham.Tales of the prowess of Hercules—and his promiscuity—passed fromgeneration to generation in Greece. The modern hero of the investment worldhas similar characteristics and impact. On the Internet, we found thousands of165
166 Practical Speculationarticles eulogizing Graham and not a single one with any negatives. The mostfrequent epithets: “father of security analysis,” “a prophet,” “the legendary investor,” “founder of value investing,” “master of the investment game,” “theConfucius of value investing,” “pioneer of value investing,” and “the reveredmentor to the most successful investors of all time.” Graham is said to haveamassed a fortune by following a method of buying stocks selling below halftheir net cash liquidation value. The method is outlined in Graham and Dodd’sSecurity Analysis, a book widely known as the bible of value investing.1Graham’s followers include such famous and successful investors as hisformer student Warren Buffett, who was active during his mentor’s lifetimein leading worshipful tributes to him. “We are here for only one reason,” Buffett said on a cruise with Graham that he organized for wealthy investors, “tolisten to the wisdom of Benjamin.”Like most legends, many of these encomiums are half-truthsat best.
Illusory BargainsLet’s start with the difficulties of buying companies at 50 percent of net current asset value. Common sense would tell you that if a business were sellingat half its net liquidating cash value, the major owners or the chief executiveor their friends or the company’s bankers or accountants would quickly buythe stock for themselves and their families and good friends, and then liquidate immediately at a beautiful premium.Vic operated one of the most extensive merger-and-acquisition businesses in the United States for more than 35 years. In the course of his business, he visited tens of thousands of privately held companies. He neverfound a single one available for such a price. Nor has anyone else he knows of.The stock exchange in the 1930s seemed to offer such bargains. However,high commissions and wide spreads between bid and ask prices made thebargains illusory.Modern companies that seem to have Graham-type characteristics andhave not been gobbled up are mere will-o’-the-wisps, luring investors to buythem with bad news likely to follow. We, and all others we know of, have beenvictimized much more often than we have profited by trying to grab at suchephemera. A recent notable example came when we bought Aether Systems,a company with $50 cash value per share that was selling for only $30. Aetherlost money at such a remarkable rate that the stock slid to $2 soon after webought it. The cash value fell right along with the stock price. Vic’s daughter,
Chapter 6 • Benjamin Graham: Mythical Market Hero
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Katie, bought that one on Vic’s recommendations, and the resulting lossquickly sobered her on her budding career as a value stock picker and sent herback to finish up her PhD in psychology.Buffett also felt the lure of seemingly irresistible discounts from bookvalue. In the early days of his career, he used to like to buy such companies.Everybody in the merger business has oodles of them for sale: There are regional department stores in declining towns, distributors of American steelproducts doomed to be displaced by imports, producers of machinery for textile firms and other manufacturing businesses in the declining stage of theirlife cycles, which require huge capital investments merely to compete withmore economical modern substitutes.Certainly the tax loss provided by Berkshire Hathaway allowed Buffett tomake plenty of such acquisitions and must have been helpful in accumulatingwealth for himself and his stockholders. Finally, however, Buffett’s attorney,Charlie Munger, the legendary “Charlie” who shares the dais with him atBerkshire Hathaway’s annual meetings in Nebraska, told him in effect to stopbuying dying dinosaurs. As Charlie pointed out to Buffett, such companiestied up capital endlessly, consistently lost money, and were never able to besold at higher prices than Buffett had paid for them, because nobody elsewanted them.When Vic was in the mergers business, he found that most acquirersshare Charlie’s views. He was never so lucky as to find buyers who wouldreach for bargains regardless of future profits. Thus, when the mass marketing techniques that Vic used netted companies for sale in such fields as shoemanufacturing, retail candy stores, carpets, and so forth, he would regretfullytell the owners that he was unable to find the right potential partner for them,and that he would be happy to refer them instead to an employee stock ownership specialist. For a typical melange of companies that Vic found he couldnot sell, see the companies owned by Berkshire Hathaway, listed in the company’s annual report.Like Buffett, Vic found that the owners of such companies always werewilling to work for the new owner at salaries much lower than they currentlywere receiving—if the new owner did not interfere with their “entrepreneurialdrive and independence,” as Buffett puts it. The only mustache on the picturewas that these owners would only work for the low salary until they receivedthe highly inflated price they had agreed to sell for, or until the company cameinto some incredible good fortune that enabled it to rise from the grave.Another basic problem with Graham’s approach is that, in both theoryand practice, investors are paid to lend capital to businesses that are growingtoo quickly and earning too high a rate of return on their equity to finance
168 Practical Speculationtheir opportunities for investment from internal sources or borrowing frombanks. Companies selling at discounts tend to be those that are not growingbusinesses. By avoiding investment in such companies, one forgoes the extrareturns that are in fact available.This is all for the good. Companies tend to prosper if they produce thingsfor which there is unsatisfied demand by responding to constantly shifting andunfathomable consumer tastes and thereby giving us the goods we want in thequantities we desire. An invisible hand tends to create incentives for people tomake money, while at the same time bettering our material well being. Thisidea was first memorialized in 1776, by Adam Smith in The Wealth of Nations,developed further in Principles of Economics by Alfred Marshall 100 years later,and has since been featured in the introductory chapters of most economicstexts. The economics texts of the 1950s and 1960s were notable exceptions, asthey presented the invisible hand and the incentives as mere capitalist rationalizations for an evil system. It is our impression that those followers of Graham who have been to college were weaned on such texts.
Performance TestConsidering the great gap between Graham’s theory of value investing and thechances of putting it into practice, it is not surprising that performance of thefunds he managed was not as attractive as legend would have it. The universallyrevered apostle of prudent investing was devastated after the crash of 1929.After finishing 1928 with a 60 percent return, he lost 20 percent in 1929. Helost 50 percent more in 1930. In 1931, he lost 16 percent. In 1932, much to therelief of his investors, he lost a mere 3 percent. Journalist Janet Lowe, in Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street, wrote:Though Graham was able to stumble back and regain his footing in the marketrather quickly, after Black Tuesday, Ben’s high-risk days were over. Afterward, hestruggled to squeeze the best possible return from his investments, while at thesame time seeking that wide margin of safety. The average returns on Ben’s portfolio descended from the heights of the pre-Depression years.2
Graham always believed that a Dow of more than 100 was too high, andwhen it got there, he never again felt comfortable in the market. As the Downever fell below 100 after 1942, Graham was always leaning toward being toodefensive. In the early 1950s, when the Dow was about 300, he began to pullback from his business and advised his students against going into investing:
Chapter 6 • Benjamin Graham: Mythical Market Hero
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The market was “too high.” Because he believed for so long that the marketwas overvalued, his investment performance did not measure up to a buyand-hold strategy or any other sensible alternate strategy. In 1956, the year theDow topped 500 for the first time, he left the business for good and devotedhimself to a life of pleasure.One of the most curious—and murkiest—aspects of Graham’s performance record is the question of how much his success was attributable toGeico, the insurance company he later sold to Buffett. Graham wrote in TheIntelligent Investor that the one investment he made without following his ownmethods was the purchase of Geico.3 It is likely that the returns he realizedfrom Geico were much greater than the total returns he realized by applyinghis own methods. The insurer has also been the mainstay of Buffett’s success,providing copious cash float for arbitrage transactions.One thing we do know about the returns from following Graham’s methods. In 1976, a student founded a mutual fund devoted to putting Graham’stheories into practice. It was called the Rea-Graham fund. When the fund wasliquidated or merged in 1998, it was worth $3.6 million in assets. In this dayand age, where a fund manager with a good story can often start with $500million in seed capital and attract billions more with just a few successfulyears, the ending total assets of this fund shows that its actual performancewas meager at best.Table 6.1 shows how $10,000 invested in the Rea-Grahamfund at its inception in 1976 would have fared versus theS&P 500.Thus, we can summarize the performance in practice of Graham’smethod as follows: His performance was disastrous in the 1930s when he liquidated. He started again in the late 1930s and got out of the market in 1956,missing the move from Dow 500 to Dow 1000 over the next 20 years. A fundthat put his methods into practice from 1976 to 1996 underperformed theS&P 500 by a factor of 4 to 1.
Value’s Dismal PerformanceOn the surface, Graham’s message to buy value stocks seems perfectly reasonable. Who does not want value for his money? But there is one small problem:Contrary to widespread belief, value stocks have consistently underperformedgrowth stocks since at least 1965. The evidence was provided, quite by chance,by the venerable research firm Value Line.
170 Practical SpeculationTable 6.1 Rea-Graham Fund Performance versus S&P 500(Dividends Reinvested)Starting Investment = $10,000 (June 30, 1976)Period Ending
Rea-Graham ($)
S&P 500 ($)
12/31/7612/31/7712/31/7812/31/7912/31/8012/31/818/19/823/31/833/31/843/31/853/31/863/31/873/31/883/31/893/31/903/31/913/31/923/31/933/31/943/31/953/31/963/31/973/31/989/30/9811/15/98
10,84611,19412,35514,36215,83718,39118,85623,03523,78926,92834,38037,60238,27341,18243,10143,47845,79749,66248,21348,29154,00557,46765,21557,70960,898
10,5139,75810,39412,31216,31215,51613,82020,73422,53426,77436,81446,45542,56450,23459,87468,47376,00287,54888,825102,627135,470162,290240,000223,290247,606
]
Unintentional experiments often are provided by the gods to allow mortalsto see the light. John/Joan, who lost his penis in circumcision as an infant, wasraised as a girl. His twin brother was raised as a boy. The outcome was thatJoan acted just like a boy, and eventually reassumed the identity of a boy.4The gods of investment provided a similar unintentional experiment todetermine which class of stocks provides better long-run returns: value orgrowth. Value Line is an admirable service whose research director, SamEisenstadt, is a young-hearted person who always looks to improve his ownknowledge and the products he provides his customers, despite the firm’sgreat track record. In 1965, prompted by gains in value stocks and by Sam’sdesire to offer clients an alternate rating system, Value Line started selecting
Chapter 6 • Benjamin Graham: Mythical Market Hero
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the best value stocks in their universe. The firm divided its sample of 1,500companies into 10 groups based on value, updating the selections eachmonth. The selection system used the same key variables thatalmost everyone else uses to define value stock (i.e., price tosales, price to book, and price to earnings). But there was onedifference that today, almost four decades later, makes all thedifference in evaluating the stocks’ long-term performance. In contrast to retrospective studies of value stocks, the Value Line companies were selectedcontemporaneously. Thus, the Value Line value stock performance record is areal-life unintentional experiment with no back-testing, survivor bias, or armchair quarterbacking.The procedure has remained the same since 1965. Each group is updated each month. Results are reported every six months in Value Line’s Selection and Opinion publication. The one problem is that the firm reportsprice appreciation rather than return, and our studies have shown that thedividend yields of value stocks are 2 percent higher, on average, than those ofgrowth stocks.We report the results of