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

“Nickel Plate”). This purchase was financed by giving a note to the seller for $6,500,000 and by a cash payment of $2,000,000, which in turn was borrowed from a Cleveland bank. Subsequent acquisitions of control of many other companies were effected by various means, including the following:
    1. The formation of a private corporation for the purpose (
e.g.
, Western Corporation to acquire control of Lake Erie and Western Railroad Company, and Clover Leaf Corporation to acquire control of Toledo, St. Louis and Western Railroad Company—both in 1922).
    2. The use of the resources of one controlled railroad to acquire control of others (
e.g.
, the New York, Chicago and St. Louis Railroad Company purchased large amounts of stock of Chesapeake and Ohio Railway and Pere Marquette Railway Company during 1923–1925).
    3. The formation of a holding company to control an individual road, with sale of the holding company’s securities to the public (
e.g.
, Chesapeake Corporation, which took over control of Chesapeake and Ohio Railway Company and sold its own bonds and stock to the public, in 1927).
    4. Formation of a general holding company (
e.g.
, Alleghany Corporation, chartered in 1929. This ambitious project took over control of many railroad, coal, and miscellaneous enterprises).
    The report on the “Van Sweringen Holding Companies” made to the House of Representatives in 1930 2 includes an interesting chart showing the contrast between the control exercised by the Van Sweringens and their relatively small equity or financial interest in the capital of the enterprises controlled. On page 646 we append a summary of these data. The figures in Column
A
show the percentage of voting securities held or controlled by the Van Sweringens; the figures in Column
B
show the proportion of the “contributed capital” (bonds, stock, and surplus) actually owned directly or indirectly by them.
    2 House Report 2789, 71st Congress, 3d Session, Part 2, pp. 820–1173.
    It is worth recalling that similar use of the holding company for pyramiding control of railroad properties had been made before the war—notably in the case of the Rock Island Company. This enterprise was organized in 1902. Through an intermediate subsidiary it acquired nearlyall the common stock of the Chicago, Rock Island and Pacific Railway Company and about 60% of the capital stock of the St. Louis and San Francisco Railway Company. Against these shares the two holding companies issued large amounts of collateral trust bonds, preferred stock and common stock. In 1909 the stock of the St. Louis and San Francisco was sold. In 1915 the Rock Island Company and its intermediate subsidiary both went into bankruptcy; the stock of the operating company was taken over by the collateral trust bondholders; and the holding company stock issues were wiped out completely.

    The ignominious collapse of this venture was accepted at the time as marking the end of “high finance” in the railroad field. Yet some ten years later the same unsound practices were introduced once again, but on a larger scale and with correspondingly severer losses to investors. It remains to add that the Congressional investigation of railroad holding companies instituted in 1930 had its counterpart in a similar inquiry into the finances of the Rock Island Company made by the InterstateCommerce Commission in 1914. The memory of the financial community is proverbially and distressingly short.
    Evils of Corporate Pyramiding. The pyramiding device is harmful to the security-buying public from several standpoints. It results in the creation and sale to investors of large amounts of unsound senior securities. It produces common stocks of holding companies which are subject to deceptively rapid increases in earning power in favorable years and which are invariably made the vehicle of wild and disastrous public speculation. The possession of control by those who have no real capital investment (or a relatively minor one) is inequitable 3 and makes for irresponsible and unsound managerial policies. Finally the holding company device permits of financial practices that exaggerate the indicated earnings, dividend return, or “book value,” during boom times, and thus intensify speculative fervor and facilitate market manipulation. Of these four objections to corporate pyramiding, the first three are plainly evident, but the last one requires a certain amount of analytical treatment in order to present