Chapter 11
Finance and Business
Biting the bullet is great
if it’s someone else’s teeth.
THE MATTERS listed below are discussed in this chapter.
• Heavy debt load
• Large cash positions
• Diversification versus concentration
• Management incentives
• Highly cyclical companies in competitive industries
• Going public and going private
• Government regulation
• Who runs most companies
• Consolidated versus consolidating financial statements
• Ownership of assets with negative value
HEAVY DEBT LOAD
Like liberal accounting policies, a heavy debt load can be viewed as a good contributory reason for acquiring a common stock, even though we, in following the financial-integrity approach, tend neither to buy nor to hold such common stocks. Heavy debt loads are frequently signs of aggressive management utilizing productive assets to the utmost. As far as stock market impact is concerned, there has been a strong tendency in Wall Street, at least up until the mid-1970’s, to equate aggressive management with good management, especially in bull-market periods. Companies that had been well regarded in recent years in part because they incurred so much indebtedness were Boise Cascade, Coastal States Gas, Wilson Brothers and F. & M. Schaefer Corporation. Each, of course, eventually suffered, with a contributory factor being high fixed costs at a time of a business downturn. This, however, need not necessarily have been the case. For example, senior securities have, for many years, made up approximately 65 percent of the invested capital of electric utilities. To date, most U.S. companies in the industry have enjoyed some forty years of steady growth.
A high debt load can be an asset in a business sense as well as in a stock market sense. This occurs where the indebtedness had been incurred on an attractive basis that could not be duplicated under present conditions, no matter what the quality of the deal. For example, see the discussion of Madison Square Garden Corporation’s mortgage debt in Chapter 8.
LARGE CASH POSITIONS
Large cash holdings can sometimes be a sign of unattractiveness in a company and its common stock, either where entrenched and nonraidable managements refuse to make productive use of the funds, or where management has refused to use the funds to undertake necessary expenditures. A classic example of cash holdings being unattractive for investors is Montgomery Ward’s huge cash hoard after World War II. As an operation, Montgomery Ward fell steadily and dramatically behind its arch rival, Sears Roebuck, as Sears continued to expand by opening new stores and by entering new businesses.
In the same manner, in the late 1950’s and early 1960’s labor costs had risen so sharply in the cement industry that in order to remain competitive, it was essential for companies in the industry to undertake relatively massive capital-expenditures programs, especially for large automated kilns. In the mid-60’s, it was almost axiomatic that cement companies with strong financial positions were companies with obsolete, noncompetitive plants, whereas companies that were competitive operationally had heavy debt loads.
DIVERSIFICATION VERSUS CONCENTRATION
Corporate diversification can be viewed as a contributory reason for acquiring an equity as well as for not acquiring one. Certain managements in certain situations seem to do extremely well by having a singleness of purpose—that is, by pouring all their resources into one industry. McDonald’s is a good example of a highly successful, primarily single purpose business. Other companies that have concentrated on one line of endeavor seem to have suffered mightily for having done so. Companies in the cement and steel industries provide examples of businesses that might have fared much better had they diversified. Correspondingly, certain companies have been highly successful because of aggressive diversification into other businesses and industries. Examples include such diverse businesses as Sears Roebuck, Procter and Gamble, R. J. Reynolds and Stewart-Warner. But attempts at diversification have been anywhere from unsatisfactory to disastrous for such others as Boise Cascade, Beck Industries, Commonwealth United, Litton Industries and RCA.
There is no a priori way for concluding that corporate diversification is per se good or bad. Diversification usually requires a high order of managerial ability, in operations as well as in investing. Many authorities apparently believe that concentration on diversification was a prime cause of the Penn Central bankruptcy. The facts are that the Penn Central management had some degree of success as investors on behalf of the railroad; they apparently were abominable at operating a railroad. The contribution of cash to the railroad operations generated by Penn Central’s investments kept the business alive longer than otherwise would have been the case. The theory that the Penn Central management would have been better railroad operators had they not concentrated so much on investments may have some validity. Nonetheless, the subject seems much more debatable than one would gather merely by reading statements in the financial press.
MANAGEMENT INCENTIVES
Generous incentives may be extremely important in attracting management that can turn an unprofitable company around, but they can also be used to enrich management without any benefits to securities holders.
In one context, management compensation is a use of funds that competes directly and effectively with the interests of securities holders. Managerial salaries and expense accounts are paid before anything is used to service any securities, including such senior securities as first mortgages and commercial-bank loans. In the case of the vast majority of publicly owned companies which are profitable and which have annual sales volumes of over, say, $25 million, this is not a real problem. In most instances, management salaries and expenses are not large enough to constitute meaningful looting. However, such looting does occur often enough and is significant enough so that no stockholder in a publicly owned company should assume that securities holders have an absolute community of interest with company management. At best, and as is pointed out in Chapter 9, they have only partial communities of interest and partial conflicts of interest.
ADVANTAGES OF HIGHLY CYCLICAL COMPANIES IN COMPETITIVE INDUSTRIES
There is a tendency for companies in industries subject to adversity to attract more capable operating management, and for less dedicated personnel to run companies in basically stable industries. We remember being impressed in the late 1950’s with certain machine-tool and metal-processing company managements who had to compete in an environment marked by increased competition, large-scale technological innovation and sharp cyclical downturns in overall demand. We compared these people with managements of certain telephone companies insulated behind government-granted monopolies. The comparison was such that a good argument could be made for tending to prefer investment in going-concern operations in highly competitive, highly cyclical environments despite their obvious other faults, especially where the common stocks of these companies appeared attractive based on the four standards of the financial-integrity approach.
It is true also that companies in highly cyclical industries tend to be well financed and relatively liquid. They cannot afford not to be. This seems particularly true for second-level American companies in basic manufacturing industries.
GOING PUBLIC AND GOING PRIVATE
It is important to remember that what a business is worth as a private enterprise is different from what the equities will be valued at in the stock market when the issue is public. Sometimes the market values the public will attribute to a business are well in excess of what the company would be worth as a private enterprise. There is a tendency to take advantage of this by making private companies go public through the issuance to outside investors of equities—common stock, convertibles and warrants. (When a company goes public for the first time, it almost always has to market common stock, since for convertibles or warrants to be attractive, they have to give holders the right to convert into or to purchase a public issue.)
There are two ways for a private company to go public. The first is by the sale to the public of equities via registering an issue with the Securities and Exchange Commission and then offering shares to the public, usually by means of an underwriting. Some of the techniques of doing this are discussed in detail in Appendix I. The second method for going public is to sell out to a company that is already public for cash, equities or other securities in either a taxable transaction or a tax-free reorganization. Examples of companies that have gone public this way, in whole or in part, include Martin Processing merging into HCA Industries (now Martin Processing) and Coroon and Reynolds being acquired by Reliance Insurance in exchange for Class A Reliance common.
Frequently, however, public businesses may be worth much more as private enterprises than as public companies. In these instances the companies go private, usually (though not always) by giving the stockholders a premium over the then current market price for the stock of the company going private. Unlike private companies going public where cash, equities or other securities can be involved, going private most frequently entails compensating the outside shareholders with cash in a taxable transaction. Companies can go private in whole or in part. Those going private in whole do so by using the proxy machinery, usually in cash transactions. Those going private in part, or semiprivate, do so either through voluntary purchases for cash or through the issuance of senior securities in exchange for common stock. Public companies that repurchase their own shares are, in effect, going private in part. Share-repurchase programs, which are briefly discussed in Chapter 15, have been undertaken by literally hundreds and perhaps thousands of companies in 1977 and 1978 alone.
GOVERNMENT REGULATION
Government regulation, especially regulation by the Securities and Exchange Commission, is also two-sided for the investor—partly beneficial, partly harmful. It appears to us that the most emphasized thrust of SEC regulation in the disclosure area has been to prevent manipulative practices (such as the use of inside information for trading purposes) and also to control trading practices effectively. However, one should realize that a truly outstanding job has been done in providing meaningful disclosures to diligent, long-term serious investors, and that the SEC has been the major agent in causing these disclosure improvements during the last ten to fifteen years for all filing companies. All U.S. companies engaged in interstate commerce with over five hundred shareholders and $1 million of assets (except those in certain regulated industries) have, since 1966, been filing companies.
| Regulatory Action | Regulatory Objective | Secondary Effect |
|---|
| Restrict investment advisers from purchasing securities they recommend to advisees | Prevent advisers from taking unfair trading advantage of advisees | Prevent advisees from getting advice from best possible sources—advisers who put their money where their mouth is |
| Simplify accounting procedures for benefit of average investor | Make financial statements more understandable for neophytes. Prevent financial statements from being used to manipulate in trading situations | Prevent sophisticated investors from obtaining adequate disclosures. Lend a measure of regulatory blessing to having investors trade speculatively (thereby discouraging upgrading of investor mentalities) |
| Prevent markets from being “conditioned” at certain critical times | Protect investors when big sales pushes are being made | Ensure that unauthorized information will be given out under the table. Deny written disclosures to those responsible enough to handle them |
| Require considerable disclosure before 5 percent or more of stock can be purchased in contested situations | Create “fair” trading environment. Protect incumbents? | Discourage contests for control, especially via stock purchases. Protect incumbents? |
| Prevent sale of nonregistered stock | Protect investors from buying securities about which disclosures haven’t been made. Prevent insiders from converting gains to cash? | Encourage the continuation of speculative bubbles by restricting the supply of overpriced stocks coming on the market |
It should be realized, though, that SEC rules and regulations are a two-edged sword. It seems as if each regulation promulgated for some primary purpose always has an unintended secondary purpose.
Examples of desirable primary effects and perhaps not so desirable secondary effects growing out of Securities and Exchange Commission rules and regulations can be seen from the table on page 182 showing various regulatory actions, the regulatory objective that gave rise to those actions, and the frequently unexpected and undesirable secondary effects of those actions.
WHO RUNS MOST COMPANIES?
One myth particularly prevalent in law is that directors run companies. Almost without exception, functioning companies are really run by their day-to-day management. Because of this myth, outside directors are finding increasingly that the liabilities they assume by being directors far outweigh the benefits they obtain. They sometimes find themselves responsible for matters in law that they cannot be responsible for in practice.
Both the theory and practice of directorships need a thorough reconsideration.
CONSOLIDATED VERSUS CONSOLIDATING FINANCIAL STATEMENTS
In Chapter 8, “Generally Accepted Accounting Principles,” we commented that there are times when GAAP places form over substance. This can occur when questions arise as to which is more meaningful for an investor—consolidated financial statements or consolidating statements that are broken down to show separate financials for the parent company, each subsidiary and the consolidated entity.
This problem is brought home if one addresses the question of when a common stock is really a senior security. Take the case of Mountain States Telephone common, 88 percent of which is owned by American Telephone. For the parent company to obtain cash to service its debt and pay dividends on its common, it has to receive dividends from the operating subsidiaries, of which Mountain States is one of the more important. Thus, in economic fact Mountain States common has most of the key attributes of being an American Telephone senior security, though it does lack one attribute—there is no legally enforceable right of Mountain States stockholders to receive dividends. Accounting recognizes this senior position of the non-American Telephone stockholders of Mountain States. In American Telephone’s consolidated accounts, this minority interest is separated out and is carried as senior to American Telephone’s capital and surplus. In economic fact the Mountain States common can, in a sense, be viewed as senior to the most senior parent-company obligations, simply because the minority shareholders have to receive dividends before such cash dividends to its other shareholder, American Telephone, can be used by American Telephone to pay interest and principal on its debt.
This same feature can be brought home even more forcefully in the case of Schenley Industries when it was 86 percent owned by Glen Alden between 1968 and 1971. Without distributions from Schenley, Glen Alden, the parent, would have been insolvent and probably could not have been made solvent by obtaining distributions from other subsidiaries; it was improbable that enough cash could be generated in short order from their other subsidiaries, either from operations or through the sale of businesses or parts of businesses. As such, the Schenley common represented by the minority interest was senior Glen Alden debt. Glen Alden had to cause Schenley to pay dividends, and the minority interest had to share in these payments on a pro-rata basis. The Glen Alden debentures, of which some $700 million were outstanding, could be properly viewed as Glen Alden’s equity. The Glen Alden common, which was under water (that is, had no tangible net worth attributable to it), might best be viewed as a voting warrant. In any event, the legal and accounting definitions of what these securities were did not necessarily jibe with the realistic economic definitions of what they were.
In much of securities analysis, consolidated statements are all that is needed. Frequently, though, consolidated statements are insufficient for an analysis. SEC-required disclosures tend to be fairly good in providing parent-company and subsidiary financial statements when these are important for understanding 10-K’s, merger proxy statements and prospectuses.
NEGATIVE VAUES IN OWING ASSETS
Two Wall Street clichés conflict. One states, “Everything’s got a price,” meaning a positive price. The other states, “I wouldn’t own that asset if you gave it to me.” Since we believe that the ownership of most assets entails obligations and expense, we think the second cliché frequently tends to be truer than the first.
