Benjamin Graham was the author of manyinfluential investment books, including theclassic Security Analysis, now in its sixth edition.The first proponent of the value schoolof investing and founder and former presidentof the Graham-Newman corporation investmentfund, Graham taught at ColumbiaUniversity’s Graduate School of Business from1927 through 1957.
Rodney G. Klein is aWall Street historian and former student ofBenjamin Graham at UCLA. He founded theKlein Stock Market Museum & Library inMassillon, Ohio.
David M. Darst, CFA, is amanaging director of Morgan Stanley. Heserves as Chairman of the Asset AllocationCommittee and Chief Investment Strategistof the Global Wealth Management Group.Darst was the founding president of theMorgan Stanley Investment Group.

Rodney G. Klein is aWall Street historian and former student ofBenjamin Graham at UCLA. He founded theKlein Stock Market Museum & Library inMassillon, Ohio.

BENJAMIN GRAHAM on INVESTING

The McGraw-Hill Companies, Inc.

Copyright © 2009 The McGraw-Hill Companies
All right reserved.
ISBN: 978-0-07-162142-7

Contents

Chapter One

CURIOSITIES OF THE BOND LIST

Issues That Sell on Illogical Bases— Misconceptions of Investors— Some Foreign Issue Anomalies

The test of the market, like that of Barrie’s policeman, is popularly supposed to be “infallible.” Economists picture a thousand buyers and sellers congregating in the market place to match their keen wits and finally evolve the correct price for each commodity. In the securities market particularly, the word of the ticker is accepted as law, so that one often thinks of prices as determining values, instead of vice versa.

But accurate as markets generally are, they cannot claim infallibility. While vagaries are to be found in both the stock and bond lists, the latter offers the better field for study since direct comparisons are easier, especially where two issues of the same company are selling out of line. The recent universal readjustment of bond prices has produced more than the usual number of such discrepancies, so that there are many opportunities for investors to exchange their holdings for issues “just as good,” and returning a higher yield. Several of these anomalies will be discussed in the following paragraphs.

Let us first consider the case of Lorillard 7s, due 1944, and 5s, due 1951. The 7s are senior to the 5s in their claim on the company’s assets, yet they are offered at 118, to yield 5.62 per cent., while par is bid for the 5s—a 5 per cent. basis.

AN INVESTMENT MISCONCEPTION

Here then is an issue yielding five-eighths per cent more than a directly junior security. Moreover the 7s are a smaller issue, of nearer maturity. Of course the explanation of this discrepancy lies in the general prejudice against bonds selling at a high premium. The investor apparently imagines that by paying $1,180 for a $1,000 bond, he must eventually lose $180. The fallacy of this argument is well illustrated by this very example. For it would require only $59 a year to yield a straight 5 per cent on the $1,180 investment—the rate of the junior issue. But since the 7s pay $70 per bond, there is a surplus of $11 per year, which if simply accumulated without interest would at the date of maturity amount to about $300—fully $120 per bond more than the premium paid. If interest is compounded on these surpluses, the gain over the 5 per cent bond would be considerably more.

A REVERSED CASE

The reverse side of the prejudice against premium bonds is found in the instance of Baltimore & Ohio convertible 4½s, due 1933, compared with the Refunding and General 5s of 1995. Both issues are secured by the same mortgage, but the 4½s sell at 87½, yielding 5.70 per cent, while at 963/4 the 5s return only 5.16 per cent. This is all the more peculiar because the 4½s have a conversion privilege which may conceivably become valuable; their maturity is much nearer, making for greater stability in market price; and their amount is limited to the bonds now outstanding, while the Refunding 5s may be increased almost indefinitely—in fact, the 4½s are to be retired by an issue of Refunding 5s.

The cause of this discrepancy is probably twofold. In the first place, investors seem to prefer a 5 per cent coupon to any other. This is absolutely illogical, since a 4 per cent coupon on a bond bought at 80 is certainly no less attractive than 5 per cent on an issue costing par. Secondly, the public is wont to disregard that portion of the yield represented by the redemption at par of a bond purchased at a discount. The usual argument is that they don’t expect to hold the bond to maturity, and therefore cannot count on receiving par for it.

This reasoning is fallacious, because it is not necessary to hold an issue until the due date in order to recover at least part of the discount. Each year as the maturity approaches, the market value of the bond should grow closer to par—unless its yield is increased as the result of general or special conditions. In the case of long term bonds the annual advance is imperceptible, but in short or medium maturities it is very evident. So with these Baltimore & Ohio 4½s, their appreciation of 12 points to par will be spread over the comparatively short space of 13 years, adding a substantial amount to their yield.

The peculiar aspect of this question is the fact that the same investor who completely ignores the additional yield contained in a discount price is extremely adverse to buying a bond quoted at a premium. He is obsessed by the idea that the $180 premium on Lorillard 7s will have disappeared by 1941, but he pays little attention to the fact that by 1933 he will recover the $120 discount on Baltimore & Ohio 4½s.

As it happens the straight yield on this latter issue at 87½, considered as a stock, is practically equal to that of the General 5s, so that their other advantages described above render them a far more desirable security, even eliminating the discount element.

The Baltimore and Ohio new two-year notes, secured by 120 per cent in these Refunding 5s and Reading stocks, yield 5.73 per cent, against 5.17 per cent for the longer maturity. Their security is at least as good as that of the 1995 issue, and in the present unsettled bond market they can be relied on to display greater price stability because of their early redemption at par.

THE ST. PAUL ISSUES

Almost the identical situation as in the B. and O. issues is presented by Chicago, Milwaukee and St. Paul convertible 4½s of 1932, and convertible 5s of 2014. The 1932 maturity sells at 88¼ to yield 5.65 per cent., as against 97¼ and 5.14 per cent, respectively, for the long term issue. Both maturities are secured by the same mortgage, and in this case they are both convertible into common stock at par. The 5s of 2014 have some advantage in that their conversion privilege extends to 1926, four years longer than that of the 1932 issue. This feature is probably neutralized by the nearer redemption and limited amount of the latter bonds, so that the additional yield of more than one-half per cent makes these much more attractive.

There are three other St. Paul issues secured by the same mortgage as the foregoing, but not convertible. The 4½s of 2014 sell at 93½ and yield 5.39 per cent; the 4s, due 1934, yield 5.45 per cent at their present price of 84, while at 89¼ the 4s of 1925 return fully 5.65 per cent.

OTHER DISCREPANCIES

Similar discrepancies in bonds of the same mortgage are afforded by three newly reorganized roads—St. Louis and San Francisco, Pere Marquette and Missouri Pacific. In the case of the Frisco 4s and 5s of 1950, the 4s at 61 yield 7.05 per cent against only 6.48 per cent for the 5s at 80—a difference of .53 per cent. Even figuring the straight yields as stocks, the 4s return 6.57 per cent, the 5s only 6.25 per cent.

This difference is probably caused by the much larger amount of 4s outstanding—a circumstance which explains, but does not justify the variance. But there are fewer Pere Marquette 4s than 5s of 1956, yet the 4s at 71 yield 5.92 per cent, against 5.76 for the 5s at 88.

The Missouri Pacific consolidated 5s present an even more glaring discrepancy. This issue is divided into three series, due 1923, 1926 and 1965, respectively. One would naturally expect the nearer maturities to sell at a lower basis—as is usually the case; e. g. the B. and O. 5s of 1918 yield only 5.12 per cent against 5.73 per cent for the 1919 issue. But the Missouri Pacific 5s of 1923 return 6.15 per cent at 94¼, the 1926 series yields 6.22 per cent at 91½; while the 1960 maturity, which is the largest of the three series, is 90 bid—no better than a 5.60 per cent basis.

A simple analysis will indicate the absurdity of this situation. In 1923 the shortest maturity must be redeemed at par, an appreciation of 6 points. If the 1965 series is still selling on a 5.60 per cent basis, it will have gained only one-half of a point in the six years. In order to equal the advance of the 1923 issue, it would have to be selling at 96, which would be only a 5.25 per cent basis.

Incidentally it may be mentioned that the Missouri Pacific third extended 4s of 1938—which are an underlying mortgage on the main line—are now offered at 80 to yield 5.62 per cent.

It is interesting to observe that the General Electric debenture 5s of 1952 are still selling at 103, yielding 4.82 per cent, in spite of the fact that the new 6 per cent note issue due 1920, ranking equally with them, returns fully 5.70 per cent on its present price of 100¾. In the public utility field, mention may be made of the 5.37 per cent return of American Telephone and Telegraph collateral 4s of 1929 at 88, compared with 5.12 per cent on the newer 5 per cent issue due 1946 at 98¼. The 4s have the additional advantage of being legal for savings banks in some New England States.

N. Y. CENTRAL CON. 4’S

Another important railroad issue is the New York Central consolidation 4 per cent mortgage, due 1988. These bonds are virtually senior to the refunding 4½s of 2013, by which they are to be refunded. They are additionally favored by their limited authorized amount, and they yield 5.24 per cent at 77, against 4.82 per cent for the 4½s at 93¾.

In the same way Norfolk and Western General 6s of 1931, which underly the consolidated 4s of 1996 recently sold at 112?, a 4.72 per cent basis, against a yield of 4.56 per cent for the junior issue at 88.

Finally we shall invade the foreign government field and consider the peculiar case of the Japanese 4½ per cent issues of 1925. These are outstanding in two series, the “seconds” having a junior claim on the earnings of the government tobacco monopoly. Nevertheless, both series have been usually quoted at the same price, and on some occasions recently the second 4½s actually were selling above the first series. This seems strange, considering that the Cuban 5s of 1914, which follow the 1904 issue in their lien on the customs revenues, are now quoted six points under the older issue.

AN INTERESTING CASE

In some respects the most interesting discrepancy of all is to be found in the Japanese 4½s “German stamped,” which sell about seven points below the plain bonds. Although these bonds were once the property of German subjects, they are accorded exactly the same treatment as any other bonds of that issue as far as interest payments are concerned, although probably not included in the frequent purchases for the sinking fund. The punctual payment of both principal and interest is guaranteed on the face of the bond even to the citizens of hostile countries—which, as a matter of fact, does not apply in this case anyway, since the bonds are now the bona-fide property of American citizens.

A painstaking scrutiny of the bond list would probably disclose other discrepancies of the same nature as those discussed above. This article has limited itself to issues of general interest, and hopes to find some utility in suggesting to investors here and there the possibility of advantageous exchanges. These are times of rapidly shifting values, and the security owner should be on the alert to acquaint himself with new conditions affecting his holdings, nor hesitate to modify them when favorable opportunities are presented.

Chapter Two

VALUATION OF GREAT NORTHERN ORE CERTIFICATES

Based on 1914 and 1916 Operations— Life of Mines—Comparison with Porphyries—An Opinion on Present Market Price

For the average investor the annual reports of the Great Northern Iron Ore properties have been full of data but very bare of information. Instead of the familiar statement of a corporation to its stockholders they represent the accounting of trustees to beneficiaries. Hence there is no question of profit and loss, but only of receipts and disbursements. All expenditures, for instance, are lumped together for current operation or temporary investment.

Moreover, the organization of the properties is highly complicated. The trustees act both as administrators of the trust and as agents for the proprietary companies; and the latter are at the same time lessees, lessors and (since 1914) operators. Consequently the public’s knowledge of the actual operations and earnings of Great Northern Ore is remarkably limited, considering the market prominence of the shares. Some utility may attach therefore to the following analysis of the trustees’ reports. Its purpose is first to transform the financial statements into an intelligible income account and then to place a definite value upon the certificates on the basis both of their earning power and the expected life of the mines.

TRUST FORMED IN 1907

As is well known the Great Northern Iron Ore Trust was formed in 1907 by the Great Northern Railway to administer the income from various iron mines controlled along its lines. The holder of each share of railway stock was given a share of interest in the Ore Properties, making a total of 1,500,000 shares outstanding, with no par value. Some of the mines had been owned outright by the railroad, and the remainder were held under lease or varying royalties and for various periods. But all these properties had in turn been leased or sub-leased to outside operators. In many cases the royalties received from the latter were no larger than those paid to the underlying owners, and these unprofitable “leases of the second class” were gradually disposed of by the trustees. Seven of the mines owned in fee had been leased for the life of the property at a sliding scale of royalty, which has averaged under 16¢ per ton. As will be seen, these “old leases” have supplied a large proportion of the output but only a small part of the total income.

All the remaining mines (some owned, others held under lease) had been leased to U. S. Steel Corporation, represented by the Great Western Mining Co. The contract provided for annually increasing production at an average royalty of $1.18 net per ton. In 1912 the output under this lease approximated 7,500,000 tons and the net royalties exceeded $9,000,000. At this time the Department of Justice, for some unaccountable reason, began to question the legality of the Great Western lease and its threat of prosecution under the Sherman Act compelled the Steel Corporation to exercise its option of cancelling the contract to take final effect at the end of 1914.

STATE OF UNSETTLEMENT

The abrogation of this important agreement plunged the affairs of the properties in a state of great unsettlement, from which they have not yet completely recovered. Some of the mines relinquished by the Steel Corporation were leased to others, a number have been operated by the trustees, and the remainder were still idle at the close of the last fiscal year. Consequently the 1916 report is probably not as good an index of the properties’ normal earning power as that of 1914, the last year of the Great Western lease. We intend accordingly to value the certificates on the basis both of 1914 and 1916 operations.

Taking the Trustees’ report for 1914, but eliminating items not properly included in income account and making numerous other requisite adjustments, an earnings statement is evolved, as in Table I.

It thus appears that the actual earnings in 1914 were $2.37 per certificate, against 53¢ net per certificate received by the Trustees in the form of distributions by the proprietary companies.

The next step in valuing the certificates is the determination of the life of the mines on the basis of present ore reserves and 1914 production.

LIFE OF MINES

For greater accuracy we will consider the “old leases” and the Great Western lease separately. From estimates made by the Great Western Mining Company, it appears that on December 31 last, the lands formerly under lease to that company contained about 203,000,000 tons of ore. Production in 1916 aggregated 6,014,000 tons, so that if the 1914 rate of output were maintained in the future these mines would be exhausted in 34 years.

Earnings from these properties in 1914, including for convenience miscellaneous receipts less expenses, totalled $2.15 per share. By the so-called 7 per cent and 4 per cent standard of valuation, the interest of each certificate in these earnings would be worth $25.40. Briefly explained, the earnings of $2.15 would allow a 7 per cent return on the valuation of $25.40, and in addition yield an annual excess ($.372) which if compounded at 4 per cent will upon the exhaustion of the mine in 34 years amount to the full $25.40.

Ore remaining in the mines held under the “old leases” on December 31 last, according to estimates made by the Minnesota Tax Commission, equalled 89,350,000 tons. Since the 1914 output from this source was 1,825,579 tons, this rate of production would give the properties in question a life of 49 years. Earnings from the “old leases” amounted to only 22¢ per share. Applying the above method of valuation, the interest of each certificate in the old leases is shown to be worth only $2.86.

(Continues…)

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