Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

common-stock flotations and that even the leading banking houses were prepared to sell shares of new or virtually new commercial enterprises, without past records and on the basis entirely of their expected future earnings. (There were definite signs of this tendency in the beer-and liquor-stock flotations of 1933.) Fortunately, a reversal of sentiment has since taken place, and we find that the relatively few common-stock issues sponsored by the first-line houses are now similar in character and arrangements to those of former days. 5
    5 See, for example, the offerings of New Idea Company common in 1937, General Shoe Company common in 1938, Julius Garfinckel and Company in 1939.
    However, there has been a fair amount of activity in the common-stock flotation field since 1933, carried on by houses of secondary size or standing. Most of these issues represent shares of new enterprises, which in turn tend to fall in whatever industrial group is easiest to exploit at the time. Thus in 1933 we had many gold-, liquor- and beer-stock flotations, and in 1938–1939 there was a deluge of airplane issues. The formation of new investment companies, on the other hand, appears to be a perennial industry. In surveying such common-stock flotations, the starting point must be the realization that the investment banker behind them is not acting primarily in behalf of his clients who buy the issue. For on the one side the new corporation is not an independent entity, which can negotiate at arm’s-length with various bankers representing clients with money to invest, and on the other side, the banker is himself in part a promoter, in part a proprietor of the new business. In an important sense, he is raising funds from the public
for himself
.
    New Role of Such Investment Bankers. More exactly stated, the investment banker who floats such issues is operating in a double guise. He makes a deal on his own behalf with the originators of the enterprise, and then he makes a separate deal with the public to raise from them the funds he has promised the business. He demands—and no doubt isentitled to—a liberal reward for his pains. But the very size of his compensation introduces a significant change in his relationship to the public. For it makes a very real difference whether a stock buyer can consider the investment banker as essentially his agent and representative or must view the issuing house as a promoter-proprietor-manager of a business, endeavoring to raise funds to carry it on.
    When investment banking becomes identified with the latter approach, the interests of the general public are certain to suffer. The Securities Act of 1933 aims to safeguard the security buyer by requiring full disclosure of the pertinent facts and by extending the previously existing liability for concealment or misrepresentation. Although full disclosure is undoubtedly desirable, it may not be of much practical help except to the skilled and shrewd investor or to the trained analyst. It is to be feared that the typical stock buyer will neither read the long prospectus carefully nor understand the implications of all it contains. Modern financing methods are not far different from a magician’s bag of tricks; they can be executed in full view of the public without its being very much the wiser. The use of stock options as part of the underwriter-promoter’s compensation is one of the newer and more deceptive tricks of the trade.
    Two examples of new enterprise financing, in 1936 and 1939, will be discussed in some detail, with the object of illustrating both the character of these flotations and the technique of analysis required to appraise them. 6
    6 In the 1934 edition we analyzed, at this point, the offering of stock in Mouquin, Inc. (liquor importers) made in September 1933 at $6.75 per share. The facts showed that the public was asked to place a valuation of $1,670,000 on an enterprise with physical assets of $424,000 and no earnings record. The company passed out of existence in 1937, and the public’s investment was wiped out.
    Example A: American Bantam Car Corporation, July
1936. This offering consisted of 100,000 shares of 6% Cumulative Convertible Preference stock, sold to the public at $10 per share, its par value. Each share was convertible into 3 shares of common stock. The “underwriters” received a gross commission of $2 per share, or 20% of the selling price; however, this compensation was for selling effort only, without any