Benjamin Graham exemplified diligent, insightful financial analysis. Through a 1948 study of railroad stocks Southern Pacific and Northern Pacific in his third lecture to New York Institute of Finance, he revealed core tenets relevant even for enterprising investors today. Graham demonstrated how to dig deeper and see beyond superficial metrics to better determine a company's true earning power and intrinsic value.
The deceptive power of dividends
On the surface, Southern Pacific appeared the superior stock. It traded above $40 per share in 1948, while Northern Pacific languished around $19. This aligned directly with their dividend policies. Southern Pacific paid shareholders a generous $4 per share in annual dividends, while Northern Pacific only distributed $1 annually.
Graham understood that dividend policy heavily influences market prices. Stocks offering rich dividend yields frequently trade at premium valuations, as income-focused investors bid up shares. But in Graham's view, dividend policy reveals little about a company's actual earning potential or intrinsic business value. For true investing insight, much deeper analysis is required.
Unveiling Northern Pacific's hidden profitability
Graham revealed Northern Pacific's obscured earnings power through its 48.5% stake in the larger, more profitable Burlington Northern railroad. Yet Northern Pacific's reported profits only included the dividends received from Burlington, failing to represent its full profit entitlement from this ownership stake. When the numbers are closely analyzed, a vastly different picture emerges compared to surface-level financial metrics.
Pre-war, Northern Pacific earned 12 cents per share when factoring in its Burlington ownership, while Southern Pacific earned $1.27 per share. During the wartime railroad expansion of the 1940s, Northern Pacific earned $11.46 per share on average between 1941 and 1945 compared to Southern Pacific's $12.90 per share when including all of Burlington's undistributed earnings. Most strikingly, in 1946 Northern Pacific earned $4.60 per share pre-tax and pre-credits when incorporating its Burlington stake, while Southern Pacific actually lost $1.20 per share.
Dividend policy and earnings power
This analysis clearly demonstrates how dividend policy often misleads investors regarding earning power and intrinsic value. Pre-war, Southern Pacific handily exceeded Northern Pacific based on traditional metrics. But the earnings gap closed during the wartime railroad boom, as Burlington's obscured profitability became clearer. And in 1946, Northern Pacific dramatically outearned Southern Pacific, completely reversing perceptual narratives.
Graham shows how enterprising investors willing to dig deeper can gain advantage by: considering assets and stakes not fully reflected on the balance sheet; making apples-to-apples comparisons using pre-tax, pre-credit earnings metrics to assess profitability; recognizing accounting impacts on reported results; and focusing on true earning power rather than potentially misleading dividend policy.
LIFO accounting to reduce corporate earnings and taxes
Graham dived into an accounting method called LIFO (last-in, first-out) and how it can impact a company's financials. Though less widely used today, LIFO was popular in the 1940s and allowed companies to reduce taxable income.
The legend used department store Federated as an example. By using LIFO instead of FIFO (first-in, first-out) from 1942 to 1947, Federated reduced its inventory and taxable profit by $3.9 million. This resulted in $2.6 million in tax savings, while reducing after-tax profits by nearly $1.2 million.
Understanding LIFO's impact
The lower reported profit minimized taxes but understated earnings. Graham views LIFO as similar to accelerated wartime depreciation, where assets were written down faster to garner tax credits while reducing apparent profits.
For investors, the key is recognizing LIFO's impact on financials. Federated's balance sheet understated inventory value, but LIFO also provided an earnings cushion if inventory declined. Graham stresses analyzing pre-tax earnings to assess true profitability.
Graham's core financial analysis principles
Several further crucial lessons emerge from Graham's insightful railroad analysis. He analyzed fixed-charge coverage ratios in granular detail, looking past summary figures to underlying realities. Graham also factored equipment rentals into overall fixed expenses along with traditional interest expenses to better evaluate financial strength.
Additionally, he complemented rigorous quantitative analysis with relevant business and industry qualitative assessments. But Graham found financial quantitative factors typically provided more concrete insights than generalizations based on broad regional predictions or outlooks. Most importantly, Graham focused on evaluating enduring shareholder returns and earnings power, not emphasizing accounting earnings metrics which can be distorted by temporary factors.
The timeless relevance of Graham's techniques
While specifics like LIFO inventory accounting and equipment rental policies are less directly relevant for analysis today, Graham's core principles remain highly instructive for prudently analyzing stocks in modern markets: scrutinizing pre-tax, pre-credit earnings to accurately assess profitability; accounting for hidden assets and unconsolidated stakes not reflected in top-level financial statements; adjusting for accounting policies that may obscure true earning power over time; weighing both key quantitative and qualitative factors; maintaining healthy skepticism of optics like dividend policy that may heavily influence investor perceptions; and staying focused on genuinely durable earning power and expected shareholder returns rather than potentially distorted accounting earnings.
Graham's legacy in financial analysis
Graham proved himself a true master of holistic, insightful financial analysis. By seeing through poor proxies like dividend policy and simplistic regional railroad judgments, he revealed the obscured drivers of earning power and intrinsic value. His example provides a model for enterprising investors today to progress beyond superficial heuristics and develop a deeper analytical edge.
Investing with a Graham-like lens undoubtedly requires hard work - dissecting financial reports, understanding key accounting policies and forming independent judgments. But diligent analysis allows investors to see beyond surface-level metrics and unlock Graham's goal of uncovering underappreciated value in the financial markets. Nearly a century later, Graham's techniques for thoughtful financial analysis remain highly instructive to investors willing to put in the effort to advance beyond simplistic shortcuts. His teachings embody timeless wisdom for those seeking to excel at security analysis.
