Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value by David L. Dodd Page A
Authors: David L. Dodd
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kind are convenient for the authors since they do not involve the risk of some later mischance casting doubt upon their judgment. To avoid loading the dice too heavily in our favor, we add another illustration which is current as this chapter is written.
A Current Example
. Choctaw and Memphis Railroad Company First 5s, due 1949, were selling in 1939 at about 35, carrying more than 5 years’ unpaid interest. They were a first lien on underlying mileage of the Chicago, Rock Island and Pacific System. The Rock Island had been reporting poor earnings since 1930, and all its obligations were in default. However, a segregation of the 1937 earnings by mortgage divisions showed that the Choctaw and Memphis mileage was very profitable and that its interest charges had been covered 2.6 times in that year even though the company had earned only $2,700,000 toward total interest of $14,080,000. Furthermore, the several reorganization plans presented up to 1939, including that of the I.C.C. examiner, had all provided for principal and back interest on this issue in full, although virtually the entire remaining bond structure was to be drastically cut down, and total interest charges were to be reduced to less than $2,500,000 annually.
Assuming, as seemed inevitable, that the company was to be reorganized along the lines proposed, it was clear that these Choctaw and Memphis bonds would enjoy a very strong position, whether they were to be left undisturbed with their lien on a valuable mileage and their back interest paid off, or were to be given par for par in a new, small first mortgage on the entire system. This conclusion would be inescapable unless it were true that a railroad with minimum gross earnings of 65 millions could not be counted on to meet charges of 2½ millions annually—less than
one-fifth
its former burden.
Thus all the quantitative factors would seem to indicate strongly that the Choctaw and Memphis 5s were greatly undervalued at 35 and that
once the recapitalization was completed
the entrenched position of this issue should become manifest. 4
4 See Appendix Note 67, p. 835 on accompanying CD, for text of the material in the 1934 edition relating to the Fox Film 6% Notes, due 1936, which in 1933 were selling at 75 to yield 20% to maturity.
Price-value Discrepancies in Receiverships. In Chap. 18, dealing with reorganization procedure, we gave two diverse examples of disparities arising under a receivership: the Fisk Rubber case, in which the obligations sold at a ridiculously low price compared with the current assets available for them; and the Studebaker case, in which the price of the 6% notes was clearly out of line with that of the stock. A general statement may fairly be made that in cases where substantial values are ultimately realized out of a receivership, the senior securities will be found to have sold at much too low a price. This characteristic has a twofold consequence. It has previously led us to advise strongly against buying at investment levels
any
securities of a company that is likely to fall into financial difficulties; it now leads us to suggest that
after
these difficulties have arisen they may produce attractive analytical opportunities.
This will be true not only of issues so strongly entrenched as to come through reorganization unscathed (
e.g.
, Brooklyn Union Elevated 5s, as described in Chap. 2) but also of senior securities which are “scaled down” or otherwise affected in a readjustment plan. It seems to hold mostconsistently in cases where liquidation or a sale to outside interests results ultimately in a cash distribution or its equivalent.
Examples
: Three typical examples of such a consummation are given herewith.
1.
Ontario Power Service Corporation First 5½s, Due 1950
. This issue defaulted interest payment on July 1, 1932. About this time the bonds sold as low as 21. The Hydro-Electric Commission of Ontario purchased the property soon afterwards, on a basis that gave
A Current Example
. Choctaw and Memphis Railroad Company First 5s, due 1949, were selling in 1939 at about 35, carrying more than 5 years’ unpaid interest. They were a first lien on underlying mileage of the Chicago, Rock Island and Pacific System. The Rock Island had been reporting poor earnings since 1930, and all its obligations were in default. However, a segregation of the 1937 earnings by mortgage divisions showed that the Choctaw and Memphis mileage was very profitable and that its interest charges had been covered 2.6 times in that year even though the company had earned only $2,700,000 toward total interest of $14,080,000. Furthermore, the several reorganization plans presented up to 1939, including that of the I.C.C. examiner, had all provided for principal and back interest on this issue in full, although virtually the entire remaining bond structure was to be drastically cut down, and total interest charges were to be reduced to less than $2,500,000 annually.
Assuming, as seemed inevitable, that the company was to be reorganized along the lines proposed, it was clear that these Choctaw and Memphis bonds would enjoy a very strong position, whether they were to be left undisturbed with their lien on a valuable mileage and their back interest paid off, or were to be given par for par in a new, small first mortgage on the entire system. This conclusion would be inescapable unless it were true that a railroad with minimum gross earnings of 65 millions could not be counted on to meet charges of 2½ millions annually—less than
one-fifth
its former burden.
Thus all the quantitative factors would seem to indicate strongly that the Choctaw and Memphis 5s were greatly undervalued at 35 and that
once the recapitalization was completed
the entrenched position of this issue should become manifest. 4
4 See Appendix Note 67, p. 835 on accompanying CD, for text of the material in the 1934 edition relating to the Fox Film 6% Notes, due 1936, which in 1933 were selling at 75 to yield 20% to maturity.
Price-value Discrepancies in Receiverships. In Chap. 18, dealing with reorganization procedure, we gave two diverse examples of disparities arising under a receivership: the Fisk Rubber case, in which the obligations sold at a ridiculously low price compared with the current assets available for them; and the Studebaker case, in which the price of the 6% notes was clearly out of line with that of the stock. A general statement may fairly be made that in cases where substantial values are ultimately realized out of a receivership, the senior securities will be found to have sold at much too low a price. This characteristic has a twofold consequence. It has previously led us to advise strongly against buying at investment levels
any
securities of a company that is likely to fall into financial difficulties; it now leads us to suggest that
after
these difficulties have arisen they may produce attractive analytical opportunities.
This will be true not only of issues so strongly entrenched as to come through reorganization unscathed (
e.g.
, Brooklyn Union Elevated 5s, as described in Chap. 2) but also of senior securities which are “scaled down” or otherwise affected in a readjustment plan. It seems to hold mostconsistently in cases where liquidation or a sale to outside interests results ultimately in a cash distribution or its equivalent.
Examples
: Three typical examples of such a consummation are given herewith.
1.
Ontario Power Service Corporation First 5½s, Due 1950
. This issue defaulted interest payment on July 1, 1932. About this time the bonds sold as low as 21. The Hydro-Electric Commission of Ontario purchased the property soon afterwards, on a basis that gave
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