The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
In this article, Graham gives four examples of scenarios that represent the extremes that can occur on Wall Street.
Penn Central (Railroad) Co - An extreme example of a failure to recognize the warning signals of financial weakness.
Investors failed to recognize that the interest coverage ratio (1.9x) failed to meet the bottom threshold of 5x that Graham sets out. Investors ignored the fact that earnings per share were being published BEFORE special charges associated with an ill-conceived merger, and that AFTER these charges, the EPS was negative (the investors pushed the price upward anyways). Further, even after considering all the quantitative problems with the company, investors ignored the fact that use of railroads was going down and Penn Central was losing a greater share than its competitors.
Present-Day Comparison: Lucent Technologies (LU) vastly overpaying for Chromatis Networks
Moral: Always conduct a proper analysis! Failure to recognize warning signs will lead to inconsistent returns at best, major losses at worst.
Ling-Temco-Vought Inc - An extreme example of empire building.
James Ling started a company that began acquiring dozens of unrelated companies. These acquisitions were funded by LTV stock. The more acquisitions LTV made, the higher its stock went, which meant that LTV could afford more acquisitions. This was a house of cards that inevitably came crashing down.
Present-Day Comparison: Tyco International (TYC) (Acquired 200 companies in 2000 alone!)
Moral: Unrelated acquisitions are often ill-conceived and lead to poor returns. Watch out for companies that appear to be empire building.
NVF Corp - An extreme example of a corporate acquisition of a company seven times its size, which led to huge debt. In doing so, the company employed accounting gimmicks with a series of undecipherable entries to make the company seem far more attractive than it is.
Present-Day Comparison: AOL-TimeWarner (AOL shareholders getting 55% of the newly merged firm, despite TimeWarner being 5x the size!)
Moral: Be careful about companies that have taken on enormous amounts of debt to purchase larger companies. This may make the new entity unsustainable. Be extra careful when the subsequent financial statements are shady, as this is a good sign that management bit off more than it can chew and is now trying to hide its mistake.
AAA Enterprises - An extreme example of public stock financing of a small company.
The owner had begun franchising his business which only earned $61,000 before tax. He went public, selling at 115x earnings due to the franchising concept. Ultimately, it crashed.
Present-Day Comparison: eToys (went public, becoming valued at $7.8 billion on the first day, when it only had losses to show for itself. It was spending $2 for every $1 in sales!)
Moral: Don’t fall for ambitious plans for the future or other “hot issues.” Buy based on historical performance of the underlying company.