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Four extreme case histories

Graham's four cautionary tales from 1968–1971, the warning signs each one showed, and Zweig's parallels from the dot-com years.

FinanceGraham ch. 17About 7 min: 4 reading, 3 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Name the four patterns in Graham's case histories
  • Identify the simple warning sign in each case
  • Match Zweig's modern cases to Graham's patterns
The Intelligent Investor: Benjamin Graham's ideas: lesson 18 of 24
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 5
  10. Defensive investors and stocks 4 min
  11. Graham ch. 6
  12. What the enterprising investor avoids 4 min
  13. Graham ch. 7
  14. What the enterprising investor does 5 min
  15. Graham ch. 8
  16. Mr. Market 5 min
  17. Living with fluctuations 5 min
  18. Graham ch. 9
  19. Investing in funds 5 min
  20. Graham ch. 10
  21. The investor and his advisers 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 13
  27. Comparing four companies 4 min
  28. Graham ch. 14
  29. The defensive investor's screen 4 min
  30. Graham ch. 15
  31. The enterprising investor's screen 7 min
  32. Graham ch. 16
  33. Convertibles and warrants 6 min
  34. Graham ch. 17
  35. Four extreme case histories 7 min
  36. Graham ch. 18
  37. Eight pairs of companies 7 min
  38. Graham ch. 19
  39. Shareholders, managements and dividends 5 min
  40. Graham ch. 20
  41. Margin of safety (1): the idea 5 min
  42. Margin of safety (2): in practice 7 min
  43. Graham appendix 1
  44. The superinvestors of Graham-and-Doddsville 6 min
  45. Graham postscript
  46. Graham today 7 min

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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 17, "Four Extremely Instructive Case Histories"

What it is

Graham chose four companies, each an extreme of a different kind. They are taught here as patterns to recognise, not as stories about particular firms.

PatternGraham's caseThe warning sign
A tottering giant at a high pricePenn CentralInterest barely covered
Empire building on debtLing-Temco-VoughtHuge bank loans
A small firm swallowing a big oneNVF and Sharon SteelDebt far above equity
A hot new issueAAA EnterprisesA price far above earnings

Penn Central. The largest US railroad went bankrupt in 1970. Its stock fell from 86½ in 1968 to 5½. Graham argues the simplest checks showed the danger:

  • Its interest was covered 1.91 and 1.98 times as reported in 1967 and 1968, which Graham reckons was under 2 times before tax, against the 5 times his Security Analysis requires for railroad bonds.
  • It had paid almost no income tax for 11 years, which should have raised doubts about its reported earnings.
  • Its bondholders could have swapped, at no loss of price or income, into far better-covered utility bonds.

Ling-Temco-Vought. A fast-built conglomerate. Its bank loans rose from 161 million dollars at the end of 1967 to 414 million a year later, and its total debt reached about 1.9 billion dollars by 1969. The stock, offered to the public at 111 late in 1967, fell to 7⅛ by 1970. Graham's question: how could the banks have lent so much to a company that failed conservative standards?

NVF and Sharon Steel. In 1969 NVF took over Sharon Steel, a company about seven times its size, paying mainly with new bonds and warrants. Had it bought all the shares, the combined company would have had about 163 million dollars of debt against only 2.2 million of tangible equity.

AAA Enterprises. A small mobile-home and franchising company sold shares to the public in 1969 at 13, sponsored by a major stock-exchange firm. The price soon doubled, to what Graham calculates was 115 times its best-ever earnings. It filed for bankruptcy in January 1971.

Quick check

Tap an answer to check it.

  1. A railroad's interest is covered 1.9 times before tax. How does that compare with Graham's minimum for railroad bonds?

    Show answer

    It falls far short of his 5 times before tax. Graham's minimum for railroad bonds is 5 times before tax.

Why it matters

Graham's moral for Penn Central is that analysts should do the elementary checks first, before studying price movements or forecasts, and the same lesson runs through the other cases. The main warning signs (interest coverage, debt against equity, taxes actually paid, price against earnings) were in the published figures, though NVF's accounting took detective work to untangle.

He also blames the banks that lent so freely to Ling-Temco-Vought. On AAA he writes that the speculative public will buy anything in fashion, and he asks whether the investment houses behind such issues, and the regulators, should do more.

Zweig's parallels (2003). He gives a sampler of modern cases, each broadly matching one of Graham's patterns:

  • Lucent (the giant): a 4.8 billion dollar purchase of a firm with no revenue, most of it goodwill, and rising loans to its own customers. It lost about 190 billion dollars of market value in two and a half years.
  • Tyco (the acquirer): "non-recurring" merger charges that appeared in four of five years, totalling about 2.5 billion dollars.
  • AOL and Time Warner (the small firm buying the big one): Time Warner was the larger business by every measure except share price, yet AOL's shareholders got 55% of the combined company. Shareholders lost about 80% of their value.
  • eToys (the hot issue): in its first 20 months it lost more than it sold, yet on its first day of trading the market valued it above Toys "R" Us.

Worked example

A made-up company before a takeover:

  • Earnings before interest and tax: 60 million a year. Interest: 20 million.
  • Interest coverage = 60 ÷ 20 = 3 times.

It now borrows to buy a company, adding 25 million of interest and 15 million of earnings before interest and tax:

  • New coverage = (60 + 15) ÷ (20 + 25) = 75 ÷ 45 ≈ 1.7 times.

The company is bigger, and its reported sales and earnings may look better. But the cushion protecting its lenders has shrunk by about 44%. Graham notes that Ling-Temco-Vought's interest coverage did not meet conservative standards; for NVF the matching check is debt against tangible equity.

Common mistake

Treating size, a famous name or a respected sponsor as proof of safety. Penn Central was the country's largest railroad, and AAA's shares were sold by a leading firm. Graham's point is that the figures decide, whoever stands behind the company.

Key terms

interest coverage
earnings before interest and tax ÷ interest charges
conglomerate
a company built by buying businesses in many unrelated fields
hot issue
a new share issue whose price jumps soon after sale
non-recurring charge
a cost reported as a one-off, outside normal earnings
tangible equity
shareholders' equity minus goodwill and other intangibles

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
interest coverageearnings before interest and tax ÷ interest charges
conglomeratea company built by buying businesses in many unrelated fields
hot issuea new share issue whose price jumps soon after sale
non-recurring chargea cost reported as a one-off, outside normal earnings
tangible equityshareholders' equity minus goodwill and other intangibles

Practice

Work it through

A company earns 90 before interest and tax and pays 30 in interest. It buys another firm, adding 20 of earnings before interest and tax and 25 of interest.

Sort it

Which group does this belong to?

  1. Interest covered under 2 times at the country's largest railroad

    Show answer

    Tottering giant. Penn Central

  2. Bank loans more than doubling in a year to fund more purchases

    Show answer

    Empire building on debt. Ling-Temco-Vought

  3. A firm takes over one about seven times its size, paying in new bonds

    Show answer

    Small swallows big. NVF and Sharon Steel

  4. A new share issue doubles soon after sale, at over 100 times earnings

    Show answer

    Hot new issue. AAA Enterprises

  5. A takeover gives the smaller company's shareholders 55% of the result

    Show answer

    Small swallows big. Zweig's AOL and Time Warner case

Quick quiz

Tap an answer to check it.

  1. What was the first warning sign Graham names for Penn Central?

    Show answer

    Interest covered only about 2 times before tax, against his 5-times minimum. The figure was in the published bond guides.

  2. What is Graham's moral for Penn Central?

    Show answer

    Analysts should do the elementary checks before anything else. Penn Central's weak coverage and missing tax payments were in the published figures.

  3. Why did Zweig call Tyco's "non-recurring" charges a warning sign?

    Show answer

    They appeared in four of five years, so they were really a normal cost of its acquisitions. A charge that keeps coming back is part of the business.

In short

  • Four patterns: the tottering giant, empire building on debt, the small firm swallowing a big one, the hot new issue.
  • Each showed a simple warning sign in the published figures: coverage, debt, taxes paid, price against earnings.
  • Graham faulted the lenders and questioned the sponsors, not only the buyers.
  • Zweig (2003): Lucent, Tyco, AOL–Time Warner and eToys repeat the patterns.

Mastery check

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Check yourself

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  1. What interest coverage before tax did Graham require for railroad bonds?

    Show answer

    5 times.

  2. About how many times its own size was the company NVF took over?

    Show answer

    About seven times.

  3. A company's coverage falls from 4 to 2 times after a debt-funded purchase. By what percentage has it fallen?

    Show answer

    50%.

Further reading