Benjamin Graham: I Had "Treasure in My Hands"

This article first appeared on Valuewalk.com

 

The year was 1926, and 32-year-old Benjamin Graham was sitting in the dimly lit reading room of the Interstate Commerce Commission, scrutinizing documents.

He had taken the train to Washington D.C. from Wall Street, where he had recently started his own investment management partnership. His reputation as a savvy securities analyst and investor was growing, but this was eight years before Graham authored the classic Security Analysis, which along with The Intelligent Investor published in 1949, would help establish Graham as “The Father of Value Investing.”

Surrounded by shelves of folders pertaining to U.S. regulation of railroads, trucking companies and pipelines, Graham was transfixed on one report in particular — the balance sheet of Northern Pipeline Company. It was an out-of-favor, thinly-traded stock spun-off from Standard Oil a decade earlier. And what he found amazed him:

Unknown to anyone on Wall Street, Northern Pipeline had major holdings of high-grade bonds. By Graham’s calculation, the company, then trading at $65 per share, and paying a $6 per share dividend, was holding $95 in liquid bond assets for each share outstanding. Graham had a realization: Northern Pipeline could distribute to its stockholders $90 per share in a special dividend with no impact on the company’s operations.

Graham saw that Northern Pipeline’s actual operations were comparatively small, with large profit margins, and that the company carried no inventory. There was no need for Northern Pipeline to hold the bond investments. Even after paying out a large distribution, Northern Pipeline would remain profitable and debt-free. This would be a bonanza for shareholders.

Graham’s discovery of Northern Pipeline’s hidden assets would mark the beginning of a new era in investing and corporate governance, and earn The Father of Value Investing another distinction: The First Activist Investor.

Northern Pipeline was one of eight pipeline companies created in 1911 when the U.S. Supreme Court broke apart John D. Rockefeller Sr.’s Standard Oil monopoly. In the days before SEC mandated financial disclosure, these pipeline companies supplied only bare bones income statements and balance sheets to shareholders.

What Graham discovered -- and other investors didn’t realize -- was that each of the pipeline companies also filed a twenty-page annual report to the ICC -- the agency which oversaw the country’s transportation businesses. To Graham’s astonishment, the ICC statements of the pipeline companies contained detailed breakdowns of millions of dollars of U.S. government securities and railroad bonds held by the pipelines. And Northern Pipeline held the most securities relative to its market price of them all.

In The Memoirs of the Dean of Wall Street compiled by Seymour Chatman, Graham looked back on this defining moment in the history of activist investing and remembered feeling like an explorer encountering a new world:

“Here was I, a stout Cortez-Balboa, discovering a new Pacific with my eagle eye...I had treasure in my hands.”

Graham returned to his Wall Street office and via his investment partnership began accumulating Northern Pipeline shares. By “careful but persistent buying” over weeks, he acquired 2,000 shares out of the company’s 40,000 outstanding -- about a 5% ownership position. This made Graham the largest stockholder of record after the Rockefeller Foundation, which owned about 23 percent of all the spun-off pipeline companies.

After acquiring the sizeable stake, he decided it was time to “persuade Northern Pipeline management to do the right and obvious thing: to return a good part of the unneeded capital to the owners, the stockholders.” Naively, he thought this would be rather easy to accomplish.

In the months ahead, as Graham tried to persuade and pressure Northern Pipeline management into giving shareholders their due, the securities analyst discovered what a thousand activists have confronted in the years since:  Often the management of public companies has objectives other than maximizing shareholder value. And compelling entrenched, self-serving management to do “the right and obvious thing” may require dogged determination over many months or years. But the returns for shareholders can be well worth it....

Graham’s “Northern Pipeline Contest” as he described it, is a classic example of an investor challenging an overcapitalized company to return assets to shareholders, and one of the earliest examples of modern shareholder activism.

Benjamin Graham - Persuading Northern Pipeline to do “the right and obvious thing” for shareholders took two years

Now a major shareholder, Benjamin Graham made an appointment at Northern Pipeline’s impressive headquarters in the Standard Oil Building at 26 Broadway in Manhattan. He met with the president of the company, D.S. Bushnell, along with the company’s general counsel, who just happened to be Bushnell’s brother. Graham related his plan for distributing excess cash to the company's shareholders, while leaving operations intact.

But, as Graham puts it, the elderly gentlemen “proved much more resourceful in finding reasons to hang on to the stockholders’ pile of gold than ways to increase the profits.”

They had a series of objections to Graham’s plan:

  • The company didn’t have the required surplus for such a distribution. Graham pointed out they could issue more shares and make a payout as return of capital.

  • The company needed the surplus as working capital. Graham noted that a company doing $300,000 in revenue doesn’t need several million dollars in cash assets.

  • The Bushnell Brothers asserted the bonds were a depreciation reserve, needed for future replacement of the pipeline. The value investor suggested that using $3.6 million to replace a pipeline doing $300,000 of business would be crazy.

  • Next, the Bushnells said they might need the cash for expanding the business. Graham noted the company was a small part of the old Standard Oil main line and that there was nowhere to expand.

Finally, having run out of arguments, the Bushnells cut to the bottom line. As Graham relates, the managers told him:

“Look, Mr. Graham, we have been very patient with you and given you more of our time than we could spare. Running a pipeline is a complex and specialized business, about which you can know very little, but which we have done for a lifetime. You must give us credit for knowing better than you what is best for the company and its stockholders. If you don’t approve of our policies, may we suggest that you do what sound investors do under such circumstances, and sell your shares?”

In years to come, Graham continued to buy stakes in public companies trading well below their true, or “intrinsic” value, then acted -- by one means or another -- to close that gap. It’s the same game plan carried out by activist investors in the years since the Northern Pipeline Contest. Invariably Graham found that management resisted his endeavors, utilizing the same basic argument as the Bushnells: Management was best qualified to judge what policies were required to run a company. And if you don’t like it, sell your stock.

Benjamin Graham - A crack-brained Don Quixote tilting at a giant windmill

As Graham tells it, in the 1920’s Wall Street was largely a gentlemen’s club, governed by an elaborate set of “rules”. One of the basic rules was: “No poaching on the other man’s preserves.” This meant that anyone who was “in” -- a member of what we would now call “the Establishment” -- wouldn’t think of making any move contrary to another gentlemen member’s best interests.

In 1926 when Benjamin Graham tried to persuade a management to do something other than what it was doing, Graham said old Wall Street hands regarded him as a “crackbrained Don Quixote tilting at a giant windmill.”

However, Graham was to have the last laugh. In the months ahead, he persisted in his efforts to coerce Northern Pipeline management to distribute its bond hoard to shareholders. Though it took two years, and considerable sweat and aggravation, $70 per share was eventually distributed to shareholders, and the total value of the new Northern Pipeline stock plus the cash returned ultimately reached a total of more than $110 per old share. The company’s shareholders were nearly 70% richer than when Graham first discovered Northern Pipeline’s hidden value in the ICC reading room.

Today, some things have changed since Benjamin Graham’s first activist investor campaign, but many things have not. Due to financial reporting requirements, and the widespread dissemination of information, activists today aren’t likely to discover stocks with massive secret bond holdings. Values like in Graham’s day are rare.

But conflicts of interest between management and shareholders certainly still exist. While corporate governance standards have improved since the 1920’s, the management of many public companies -- either through self-interest or ineptitude – fail to maximize shareholder value. Today, over nine decades since Ben Graham discovered Northern Pipeline’s hidden cash, activist campaigns are more common than ever.

According to Activist Insight, 758 public companies received demands from activist investors in 2016 -- a 13% increase on 2015’s total of 673.

And if you think today’s more efficient markets limit the profit potential of activist investing, think again. In 2016, ten activist campaigns resulted in gains of 70% or more in the target company, according to Factset. It’s no wonder the investment public is fascinated with activist investing: If there’s hidden value in a company -- and an activist can access it for shareholders -- it’s possible to achieve exceptional returns.

In the following chapters, I’ll explore the most profitable strategies for following activist investors and their campaigns. I’ll investigate the strategies of the greatest activist investors operating today – like Elliott Associates and Third Point LLC – and consider the pros and cons of mimicking their moves. Obscure and first-time activists are increasing in prevalence; I’ll consider ways to profit from their moves.

I’ll discuss the merits of placing funds with activist-focused mutual funds. Shareholder activism is growing around the world -- I’ll cover the opportunities in other countries. The 13D filing is the catalyst for activist investor analysis – I’ll explain how to analyze.  What about creating one’s own customized activist strategy based on 13D filings?

 

 
Mark Gaffney