The Financial-Integrity Approach to Equity Investment

Fool me once, shame on you,
Fool me twice, shame on me.

IT HAS BEEN our observation that the most successful activists have had much the same approach to investing that the most sophisticated creditors have had toward lending. Essentially, these people approach a transaction with two attitudes, the first having to do with their order of priorities. In looking at a transaction, the single most important question seems to be, What have I got to lose? Only when it seems that risks can be controlled or minimized does the second question come up: How much can I make?

The second attitude has to do with a basic feeling that risk—how much one can lose—is essentially measured internally, not externally. The possibilities of unsatisfactory results from an investment or loan are to be found internally in the performance of the underlying business and the resources in the business, not externally in the market prices at which a company’s securities might trade. Successful activists and creditors, while not unmindful of the “value messages” that are delivered by markets, tend not to be overly influenced by such messages. Their attitude is, As far as my objectives are concerned, I know much more about the situations in which I invest or in which I lend than the stock market does.

THE FINANCIAL-INTEGRITY APPROACH

A basic premise of this book is that many noncontrol investors ought to adopt the same standards of valuation that are used by successful activists, creditors, insiders and owners of nonpublic businesses. First and foremost, they must gauge the investment risk. Key variables for doing this are the financial position of the business being analyzed and/or the financial position of the securities holder. Businesses with strong financial positions are those that have access to enough liquid funds so that they can pay for whatever reasonable requirements they might have and still have access to a comfortable amount of surplus liquidity. Earnings, even accounting earnings, are, of course, frequently an important element in determining financial strength, but this is a far cry from the position usually expounded—that for unaffiliated securities holders, earnings are the primary factor, and in fact determine value.

Companies with strong financial positions tend to be less risky than those not as well situated. Furthermore, they tend to be more expandable because of their greater ability to obtain new funds. These companies also are the most attractive candidates for asset-conversion activities, such as mergers and acquisitions, liquidations, share repurchases, takeovers and other changes in control.

Our views as developed in this book are that attractive equity investments for outside investors ought to have the following four essential characteristics:

1. The company ought to have a strong financial position, something that is measured not so much by the presence of assets as by the absence of significant encumbrances, whether a part of a balance sheet, disclosed in financial statement footnotes, or an element that is not disclosed at all in any part of financial statements.

2. The company ought to be run by reasonably honest management and control groups, especially in terms of how cognizant the insiders are of the interests of creditors and other security holders.

3. There ought to be available to the investor a reasonable amount of relevant information, although in every instance this will be something that is far short of “full disclosure”—the impossible dream for any investigator, whether activist, creditor, insider or outside investor.

4. The price at which the equity security can be bought ought to to be below the investor’s reasonable estimate of net asset value.

These four elements are the sine qua non for an investment commitment using the financial-integrity approach, because their presence results in a minimization of investment risk. But they are not simply by their presence sufficient reasons for an investment commitment. The absence, however, of any one of them is reason enough to forgo any passive investment, regardless of how attractive it might appear based on other standards.

The environment within which an investor can search meaningfully for these four characteristics is a good one. The required disclosures under the securities laws give investors good insights into the first three characteristics. Audited financial statements, including footnotes, are particularly useful in describing and enumerating many of a concern’s encumbrances, albeit some potential encumbrances, such as necessary or desirable capital expenditures, may not be disclosed. Proxy-statement disclosures about management compensation and “certain transactions” with insiders, as well as narrative Form 10-K ⁴ and financial-statement footnote disclosures about litigation, aid in determining the degree of consideration insiders are likely to have for the interests of security holders. Business descriptions in annual reports, merger proxy statements, prospectuses and 10-K’s have never been better in enabling investors to understand an enterprise.

In addition to the four essential characteristics, supplementary factors that can make an equity security attractive can be so varied as to defy anyone’s imagination. In fact, most of these factors in most analyses will exist in various combinations. To give the reader some insight into what these can consist of, we merely enumerate possible factors under three subheadings—primarily going-concern factors, primarily stock market factors and primarily asset-conversion factors. Any one or combination of these factors could serve as a “trigger to buy” securities that the investor has already determined are attractive, based on financial-integrity standards.

Primarily going-concern factors are those that relate to the operations of a business. They encompass things ranging from investor beliefs that profitability in the immediate future will increase dramatically (the dynamic-disequilibrium principle discussed in Chapter 13, “Earnings”) to tenets about dividend increases; from views that current high dividends are safe to beliefs in the potential of new developments or new research; from optimism about an industry outlook to faith in management abilities.

Primarily stock market factors encompass variables ranging from beliefs that a common stock based on existing price-earnings ratios is priced below comparable issues (the static-equilibrium concept discussed in Chapter 13), to views that the common stock looks good technically, and to ideas that the company or industry may obtain Wall Street sponsorship. Under primarily stock market factors, we would also include the myriad macrovariables that encompass investor perceptions about the economy, about interest-rate levels and about predicted movements in the general stock market or major segments of it.

Primarily asset-conversion factors that can serve as a trigger to buy can be more precisely enumerated than can factors that relate primarily to the going concern or to the stock market. Such asset-conversion factors encompass possibilities or probabilities of major refinancings, mergers and acquisitions, liquidations, certain common-stock repurchases or other large-scale distributions to common stockholders, changes in control, reorganizations and recapitalizations.

THE BENEFITS AND USES OF THE FINANCIAL-INTEGRITY APPROACH TO THE NONCONTROL INVESTOR

Outside investors using this approach buy and hold securities because issues appear at the time of purchase, and continue to appear while held, to be risk-resistant, based on the four essential elements. In contrast to other investment approaches, little or no attention is paid to stock market price fluctuations or to predictions about the immediate outlook for equity prices.

When purchasing equity securities, an outside investor using our approach will not acquire a position for his portfolio unless he believes that the value represented by the particular security is good enough, based on the four essential elements. He does not consciously try to outperform the market over the short run. Thus, investigation in areas other than financial integrity will tend to be emphasized less than it would be if the investor was striving for more immediate performance. First, little or no time is spent attempting to gauge the general market outlook, examining technical positions or making business-cycle predictions. Put simply, there is no attempt to hold off buying until the investor believes stock prices are near bottom. Rather, the primary motivation for purchases is that values are good enough. Second, comparative analysis, though always a useful tool, tends to be less important than in other forms of fundamental analysis. The reason, of course, is that the investment goal for outside investors is to concentrate on acquiring reasonable values rather than on getting the best possible values.

Such investors tend to have a degree of confidence in their commitments that just cannot exist for those who are significantly affected by day-to-day or even month-to-month stock market fluctuations, or who believe that values are determined by elements based on “soft,” or always shifting, factors, such as earnings estimates, price-earnings ratios and technical market conditions. This confidence factor can afford significant rewards in the usual (though far from universal) investment instance where there has been no fundamental deterioration in the position of companies with strong finances whose common stocks are part of the investor’s portfolio. First, only an investor confident in the fundamental merits of a security finds it relatively easy to hold or average down at times when prices are depressed because there is a bear market, because earnings have declined or for whatever reason. Second, if there is confidence in fundamental merits, it becomes relatively easy to establish positions in common stocks at attractive prices when markets are depressed because of events such as panics or tight money, or because of beliefs that near-term outlooks are poor.

It is our observation that in bear markets, equity securities that are attractive by our standards may decline in price as much as, if not more than, many general market securities and market indexes. Also, in certain types of frothy markets (such as the new-issue boom of 1967 and 1968) price performance for securities attractive by financial-integrity standards tends to be much less favorable than is the case for many market indexes. Yet, we have no doubt that over time and over all types of markets, the average diligent unaffiliated investor emphasizing this approach will obtain much more satisfactory results, and a higher total return, than could be obtained using any other method of investment available to him. That is why the approach generates confidence and comfort, and why almost all deal men, creditors, major investment bankers, insiders and owners of private businesses with whom we have dealt emphasize it in committing their own funds.

In using the approach, we frequently base investment decisions solely on publicly available information. For example, from 1972 to early 1977 we recommended to outside investors that they accumulate positions in Indian Head convertible debentures as well as in the common stocks of American Manufacturing Corporation, CNA Financial Corporation, First National State Bancorporation, Mountain States Telephone, National Presto Corporation, Orion Capital Corporation, Barber Oil, Source Capital, Baker Fentress and Christiana Securities, all in reliance on publicly available documents. In other instances, we accumulated positions only after complementing our study of public documents with interviews of managements and others. These other investments included Amterre Development, NN Corporation, Reserve Oil and Gas, and Vindale Corporation.

Obviously, most passive investments will be better investigated if publicly available documents can be supplemented with other information derived from talking to people known to the investigator (know-who) and from using the investigator’s special knowledge about particular companies and industries. Nonetheless, in a wide number of instances the public record alone can be quite sufficient.⁵

It may be instructive in understanding the financial-integrity approach to examine briefly the reasons for our recommendations from 1972 through early 1977, which were based solely on publicly available documents.

In the cases of Indian Head convertible debentures and CNA Financial Corporation common stock, the element triggering these acquisitions was that they were the type of postarbitrage situations discussed in Chapter 17. Postarbitrage is the period after the conclusion of an acquisition in which securities are still left in public hands. Both Indian Head and CNA, when recommended by us, were selling well below the prices at which cash tender offers had taken place and in which new groups gained control of companies. CNA itself was in a weak financial condition, but it was our view that its new and strong parent, Loew’s Corporation, would provide whatever financing CNA might need.

American Manufacturing’s principal asset was its holdings of a 28 percent interest in Eltra Corporation, a well-financed diversified manufacturing corporation.⁶ The possibility that the company’s financial position would be adversely impacted if the results of litigation were adverse seemed remote. American Manufacturing common was selling at a substantial discount from Eltra common. We hoped that someday Eltra might acquire American Manufacturing in much the same way that Getty Oil, in late 1976, proposed to acquire Skelly Oil. But without any real basis in fact that there might be an American Manufacturing-Eltra combination, we viewed American Manufacturing common stock as a special situation; with a realistic basis in fact, we would call the common stock a workout situation.

Mountain States Telephone, 88 percent owned by American Telephone, was somewhat similar. Although it was available on a more attractive statistical basis than American Telephone, there were logical reasons why American Telephone would be benefited if it owned 100 percent of all its operating subsidiaries. Meanwhile, the positive cash-carry feature of Mountain States was attractive, especially in light of the company’s record of periodically raising its dividend rate.⁷ (However, it ought to be noted that noncontrol investors holding common stocks or long-term bonds that are margined are, in terms of economic reality, lending or investing long and borrowing short. Changes in short-run interest rates, such as occurred in 1974, can result in changing a positive cash-carry to a dramatically negative one.)

First National State Bancorporation, available at a historically large discount from book value, also afforded an exceptionally high dividend return. And when National Presto was acquired by us, it was selling at a huge discount from a book value consisting largely of surplus cash; despite a clouded operating outlook, it had appeared to be a reasonable candidate for takeover and merger, based on stockholdings of certain outside groups.

Orion Capital Corporation was created out of the ashes of Equity Funding. Companies are reorganized under Chapter X⁸ of the bankruptcy statutes only after carefully scrutinized plans, which are part of the public record, are circulated and commented upon by trustees, the Securities and Exchange Commission and other interested parties. In addition to this scrutiny, a plan had to be approved by a court as fair, equitable and feasible. “Feasible,” in large measure, means that the business’s financial position is at least adequate. It was determined in the various studies submitted to the bankruptcy court that Orion’s reorganization value was in excess of $11 per share. Orion also, upon emergence from bankruptcy, appeared to be a prime takeover candidate. Orion common stock at the start of trading (when we recommended it) was priced at less than half its reorganization value as determined by the court, the trustees and the Securities and Exchange Commission.

Source Capital, Baker Fentress, Christiana Securities and Barber Oil were all closed-end investment companies whose stocks were available at large discounts from asset value. Source Capital and Barber Oil were takeover candidates. Christiana Securities was a candidate for merger with its affiliated company, E. I. duPont de Nemours.

THE SHORTCOMINGS OF THE FINANCIAL-INTEGRITY APPROACH

For activists and certain aggressive noncontrol investors using this approach, finding securities that are attractively priced based on the standards we have discussed is not as difficult as finding “do-able deals,” situations where asset conversions can be made to take place, or where there seem to be probabilities that asset conversions will take place, in the context of cash tenders for control, mergers and acquisitions, going private and liquidations. Thus, for activists in particular, the emphasis may be on spotting attractively priced do-able deals where an asset-conversion event may be made to occur. For these people, financial integrity may be only a secondary consideration; they are more willing to balance the risk-reward equation. In that sense, they differ from us in that they do not necessarily make potential risk a more important measurement than potential reward. Do-ability, which most often entails obtaining control of a business, may become the most important consideration.

The financial-integrity approach to investing is but one approach. It is not a magic formula suitable for all outside investors or even all activists. There are trade-offs and the approach has disadvantages, especially for outside investors. It requires huge amounts of work, especially reading and understanding documents. Know-who—personal relationships with those who are the shakers and movers—is also helpful, and in certain situations essential.

Using know-who does not connote using inside information. Those who use inside information for the purpose of buying and selling securities are violating both specific securities laws and more generalized antifraud provisions of law. Inside information embodies factors that are not generally known but that, if known, would be likely to have a material effect on immediate market prices. This type of information might include forthcoming earnings reports, disclosures of natural resource discoveries or a pending takeover at a price well above current markets. The use of know-who in a financial-integrity approach permits an investor who is personally acquainted with insiders to make intelligent judgments about, say, the character and ability of management, corporate long-range plans or reasons why a business would or would not be vulnerable to competitive inroads.

Timing of any individual investment where the investor lacks any element of control cannot be measured.

Frequently the most attractive securities one uncovers under the financial-integrity approach are traded in inactive markets. This tends to be especially true in postarbitrage periods.

The standards used to minimize investment risk limit the selection of attractive securities. Adherence to the approach results in missing many investment opportunities where securities are attractively priced by standards other than those used by risk-averse investors. In following the approach, an investor, whether activist or outsider, will forgo many equity investments regardless of price if they do not meet all four essential conditions. For example, an emphasis on financial position could prevent one from investing in airline equities (with the possible exceptions of Delta Air Lines and Northwest Airlines), because of a belief that the industry is dangerously financed (an example of on-balance-sheet liabilities) and would be even if reequipment programs were modified; in integrated steel and aluminum companies; in many electric utilities, because they may be encumbered with inordinately large capital expenditures requirements (an example of encumbrances that are not disclosed in accounting statements); and in labor-intensive companies with large pension-plan obligations (an example of off-balance-sheet liabilities that are disclosed in financial-statement footnotes). This does not mean that at certain prices such securities are not very attractive investments for many. They just do not happen to be attractive for adherents to our approach.

Under the financial-integrity approach, securities of issuers controlled by those believed to be predators should be avoided, regardless of price, by both activists and outsiders. The securities avoided are both equities and debt instruments. Significant clues as to who the predators might be are publicly available from documents filed with the SEC. These clues are discussed in Chapter 6, “Following the Paper Trail.” Especially pertinent in these documents are disclosures about management remuneration, insider borrowings from the company and transactions between the company and insiders. These disclosures are contained either in the annual-meeting proxy statement or in Part II of the 10-K Annual Report. Disclosures about “litigation” in Part I of the 10-K Annual Report, Part II of the 10-Q Quarterly Report and in footnotes to audited financial statements can also give valuable clues to the caliber of management and control groups. Disclosure of grievances by creditors or securities holders that culminate in lawsuits brought against companies and insiders should serve as warnings that a particular company may not be a satisfactory investment using a risk-minimization approach.

Those using the approach restrict investments to situations where considerable knowledge about companies can be obtained. This is true for both control and noncontrol investors. While reliance on public information only is sufficient—or even more than sufficient for certain types of investments, such as investment companies registered under the Investment Act of 1940 and public utilities—in other areas required public information frequently provides insufficient data for making intelligent decisions, as is usually the case when a company is engaged primarily in mineral exploration activities.

There is a close correlation between the usefulness of financial accounting and the usefulness of public disclosures as tools for making investment decisions. As accounting becomes more reliable, so do required public disclosures.

Most important, since the control and noncontrol groups value using the same standards, there tend to be clear conflicts of interest between insiders and outsiders. Insiders sometimes will create additional values for themselves by forcing out outsiders via the corporation’s proxy machinery that they control, by short-form mergers ⁹ or by the use of coercive tender offers. Force-outs sometimes can be at extremely low prices, because the insiders, by their actions (or lack of actions), have contributed to the depression of stock prices.

This conflict of interest presents a realistic threat that limits the appeal of a number of equity securities that would otherwise seem attractive using our approach. It is our observation that attempted force-outs at prices we would consider unconscionably low—as in the cases of Schenley Industries in 1971, Transocean Oil in 1974, Kirby Lumber in 1974, Bourns Corporation in 1976 and Valhi Corporation in 1977—are relatively infrequent.

Basically, we think most control groups in most situations attempt to treat their stockholders fairly or are forced to do so by circumstances. Examples of treatment of outside stockholders where prices offered were fair or even generous abound. These include those paid for minority interests in Indian Head, Hudson Pharmaceutical Corporation, Elgin National Industries, Utah International, Otis Elevator Company, Marcor, Veeder Industries and many others.

Nonetheless, outside stockholders are sometimes treated unfairly, and legal recourses available to stockholders are frequently inadequate. First, those who overreach at the expense of stockholders have the independent-appraisal weapon in their arsenal. Major or secondtier investment-banking houses can be retained either to recommend a force-out price or to approve one chosen by boards of directors. Many independent appraisals seem to be based on a theory that if stockholders are given more than they could realize by sale of the shares on the open market, then the deal is per se fair. No real reference is ever made to any standards other than stock-price standards.

Stockholder claims of violations of federal securities law may be only of limited help, since in most instances such suits are controlled by attorneys for stockholders who frequently have to be primarily interested in promoting settlements rather than obtaining full dollar value for stockholders. Federal securities laws are basically concerned with disclosures and with fulfilling fiduciary obligations, not fairness. A recent Supreme Court decision in Ernst & Ernst v. Hochfelder, however, raises some question as to what can be brought to bear by the private bar against professionals such as auditors who fail to fulfill professional obligations insofar as federal antifraud securities laws are concerned. In Hochfelder, the Court said that an auditor is not responsible under antifraud statutes for his own “inexcusable negligence” when conducting an audit, but, rather, he may or may not be responsible where there is “reckless disregard for the truth,” and that the auditor is clearly liable under the antifraud statutes only if he is “an intentional participant in a scheme.”¹⁰

Resort to appraisal rights under state law where available is of only limited usefulness because in leading states (a) considerable weight in arriving at value is usually given to market prices, and (b) costs of litigation for dissenting stockholders can be enormous.¹¹

State law can be helpful in affording some protection to outside stockholders in force-out situations. This has become true especially since the supreme court of the leading corporate state, Delaware, ruled in 1977 that force-out transactions ought to have “business purposes,” and that stockholders are entitled to “entire fairness.”¹² Also, a few states, notably New York, Wisconsin and California, have laws specifically designed to protect stockholders from being unfairly forced out in going-private transactions.¹³ Nonetheless, overall protection for stockholders seems to be limited.

Despite the less than strong legal posture of outside, passive stockholders, we think that in general the threat of forcing out stockholders by predatory managements and control groups is not a realistic deterrent to an investment program based on the financial-integrity approach.

We think that a crucial reason why our approach has been largely ignored in accounting and economic literature is that those writing on the subject tend to attribute the perceived information and analytic needs of traders seeking to maximize total return to all investors.¹⁴ Along with others, we believe that it is futile for outside investors to strive for the maximization of total return. It is our thesis that by not trading and by concentrating on a risk-minimizing approach, outside investors can achieve good-enough results, probably “beating the market” from time to time and on an overall basis, but never continuously. For the vast majority of noncontrol investors, the best way to wealth is not to try for continuous short-term maximization, but to aim for a performance that is good enough over a long horizon. This viewpoint is explored in some depth in the next chapter, “The Significance of Market Performance.”

Our approach has, as a practical matter, little to contribute to or learn from efficient-market and efficient-portfolio hypotheses. Such theories are probably valid in describing past records and prognoses for total-return, outside, passive traders. However, these theories are largely irrelevant to any financial-integrity approach.

In order to use our approach well, both activists and passive investors should have practical perspectives about risk and uncertainty. Investors using the approach need patience and fortitude if their investment programs are to succeed. After all, the underlying thesis for the investor is that, given the elements that determine value for him, he knows much more about the particular security he is interested in than the stock market does.

The conventional view of risk in equity securities involves only quality-of-the-issuer considerations.¹⁵ Our approach is different. For us, risk in equity securities has three distinct elements: quality of the issuer, price of the issue and financial position of the holder.

Section Three, “Disclosures and Information,” consists of one nonaccounting chapter, “Following the Paper Trail,” and two accounting chapters, “Financial Accounting” and “Generally Accepted Accounting Principles.” This section describes the types of disclosures available publicly, and discusses their uses and limitations within the context of the financial-integrity approach. Possibly the most important lesson in this section is that once the limitations on public disclosures are understood, the types of disclosures available are not only highly relevant to a great deal of analysis, but also extremely reliable for those following our approach.

Understanding the various factors that make businesses and financial institutions tick is helpful for those using our approach. There are four acronyms that serve as a slang shorthand in helping investors understand businesses, insiders and financial institutions: TS, OPM, AFF and SOTT. TS stands for Tax Shelter, OPM (pronounced “opium”) for Other People’s Money, AFF for Accounting Fudge Factor (something especially relevant for public companies) and SOTT for Something Off The Top. The normal academic assumption is that, as a good first approximation, managements work in the best interests of stockholders. We believe that relationships between managements and stockholders, between managements and companies, between companies and stockholders and between stockholder groups are best viewed as combinations of conflicts of interests and communities of interests.

The normal security-analysis assumption is that certain financial factors, such as large returns on investment, are good per se, and such others as intense competition are bad per se; we demur. Appropriate judgments about most analytical factors, including high profit margins or rapid expansion, depend upon context.

In minimizing investment risk, it is important to distinguish among variables, depending upon the types of companies being evaluated. Oil companies are not analyzed in the same way electric utilities are, nor are primarily asset-conversion businesses analyzed as going concerns are. As we stated before, much of conventional analysis, such as that of Graham and Dodd and Accounting Principles, ¹⁶ seems to be implicitly based on taking tools especially applicable to a relatively narrow, special case—the equity securities of public-utility going concerns for example—and then trying to fit those standards to the analysis of almost every type of business and security. Such an approach allows earnings to become a common denominator and point of departure. We, in contrast, consider financial integrity to be the more appropriate common denominator and point of departure for most investors.

Financial statements provide the basis for the determination of financial integrity. In determining financial position, it must be noted that the several financial statements are integrally related to each other: there are necessary relationships between book asset values and accounting earnings as well as between estimated asset values and estimated earning power.

As stated previously, we discount the importance of the concept of primacy of earnings for anyone other than total-return traders and possibly also investors in companies that are special cases, such as public utilities. It is our view that those emphasizing reported earnings are, for a number of reasons, out of step with almost everybody in the United States aiming at wealth creation. First, when primacy-of-earnings advocates refer to earnings, they tend to mean earnings as reported for accounting purposes, with a view to giving such a number a high degree of precision, precisely reflective of operating results for a past period; investment results, for example, are normally excluded by these people from earnings. Second, these reported earnings tend to be stressed for two purposes: they are thought to be the single best indicator of what future reported earnings are likely to be (here again we do not agree), and earnings as actually reported are deemed to be at any given moment the single most important contributor in determining the market price of a common stock. We also tend to believe that earnings as reported at any time will impact stock prices. We, however, conclude that in general any such impact lacks significant relevance in a risk-minimizing approach to investments.

Corporate cash and the uses to which it can be put, including distributions to shareholders, are, of course, important to investors. There is an inherent conflict between stockholder needs and benefits from cash distributions, and the needs of companies to retain cash.

There are various methods of distributing cash and property to shareholders, including dividends, share repurchases, liquidation distributions and stock dividends. Stockholders are far from constituting a monolithic group, and among them there are varied and sometimes conflicting interests concerning cash distributions.

In the management of securities portfolios, a positive cash-carry is frequently important—that is, the cash return from holding securities ought to be greater than the cash cost of owning the securities. This sometimes can also be important under our approach because both patience and the use of other people’s money are easier to come by if the cash return from investments exceeds the cash cost of owning them.

A basic point about loss companies is that while such companies are sources of tax benefits, for them to have value they have to be “clean shells”—companies in which benefits to be derived from the absence of liabilities for income taxes outweigh the encumbrances to be assumed, either already existing or likely to be created by future activities. This caveat, of course, is part and parcel of our approach, and it gives essentially the same advice to activists buying loss businesses as is given to outside, passive investors buying common stocks.

We think that any person involved with finance can function better if he understands the activities and motivations of other participants in finance. We attempt to impart understanding about the financial world by examining two transactions in some depth in Appendixes I and II. These appendixes are entitled “The Use of Creative Finance to Benefit Controlling Stockholders” and “Creative Finance Applied to a Corporate Takeover.”

In the first appendix, the complexities involved in taking Schaefer Brewing public in 1968 are examined. In the Schaefer case, the apparent object of the various transactions was to extract as much cash as possible from the business for the control group and still retain control of the business for that group. Although none of the securities issued to noninsiders in that transaction were suitable for financial-integrity investors, the case is still useful. First, it demonstrates that profits can be obtained in many ways by investors, as, for example, the profits garnered by those members of the public fortunate enough to obtain Schaefer Corporation common stock on the initial underwriting who then sold their stock within the ensuing eighteen months. Second, because the transaction was so complex, much is demonstrated about what motivates various purchasers of securities, from life insurance companies to total-return traders, and about various classes of securities that can be issued. Thus, the appendix is instructive because it demonstrates how insiders used the financial strength inherent in a profitable, almost debt-free business as a basis of extracting maximum cash for themselves, with the result that the successor business became heavily encumbered. The Schaefer case also briefly touches on matters that have to be the concern of any promoter or would-be promoter, including blue sky laws, the National Association of Securities Dealers (NASD) Rules of Fair Practice, Rule 144 and Registration Rights.

In the second appendix, we examine the methods by which Leasco Data Processing Company financed the purchase for cash of the blocks of shares of Reliance Insurance Company, which Leasco believed it needed to acquire if it was to obtain control of Reliance. The appendix is of interest in part because of the extremely attractive consideration that was given to providers of cash so that they obtained (a) a safe, above-average return on a tax-privileged basis as well as (b) an opportunity to participate in potential market appreciation. This was the epitome of an investment that could be deemed to be attractive using the financial-integrity approach. Yet, the transaction was also highly attractive for others, especially Leasco, because it enabled Leasco to tie up key blocks of common stock without risking cash, unless it was to obtain control of Reliance, and also to use “pooling of interests accounting” treatment in the future, with consequent beneficial effects on Leasco’s reported earnings to its stockholders.