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

consequently an artificially high quotation may readily be established for the subsidiary issue by manipulating the small amount of stock remaining in the market. This high quotation is then taken as the basis of figuring the book value (sometimes called the “break-up value”) of the share of the holding company. For an early example of these practices we may point to Tobacco Products Corporation (Va.) which owned about 80% of the common stock of United Cigar Stores Company of America. An unduly high market price seems to have been established in 1927 for the small amount of Cigar Stores stock available in the market, and this high price was used to make Tobacco Products shares appear attractive to the unwary buyer. The thoroughly objectionable accounting and stock dividend policies of United Cigar Stores, which we have previously discussed, were adjuncts to this manipulative campaign.
    The most extraordinary example of such exaggeration of the book value is found, perhaps, in the case of Electric Bond and Share Company and was founded on its ownership of most of the American and Foreign Power Company warrants. The whole set-up seems to have been contrived to induce the public to pay absolutely fantastic prices without their complete absurdity being too apparent. A brief review of the various steps in this phantasmagoria of inflated values should be illuminating to the student of security Analysis.
    First, American and Foreign Power Company issued in all 1,600,000 shares of common and warrants to buy 7,100,000 more shares at $25. This permitted a price to be established for the common stock that generously capitalized its earnings and prospects but paid no attention to the existence of the warrants. The quotation of the common was aided by the issuance of rights, as explained above.
    Second, the high price registered for the relatively small common-stock issue automatically created a correspondingly high value for the millions of warrants.
    Third, Electric Bond and Share could apply these high values to its large holdings of American and Foreign Power common and its enormous block of warrants, thus setting up a correspondingly inflated value for its own common stock.
    Exploitation of the Stock-purchase-warrant Device
. The result of this process, at its farthest point in 1929, was almost incredible. The earnings available for American and Foreign Power common stock had shown the following rising trend (due in good part, however, to continuous new acquisitions):

    On the theory that a “good public-utility stock is worth up to 50 times its current earnings,” a price of 199¼ per share was recorded for American and Foreign Power common. This produced in turn a price of 174 for the warrants. Hence, by the insane magic of Wall Street, earnings of $6,500,000 were transmuted into a market value of $320,000,000 for the common shares and $1,240,000,000 for the warrants, a staggering total of $1,560,000,000.
    Since over 80% of the warrants were owned by Electric Bond and Share Company, the effect of these absurd prices for American and Foreign Power junior securities was to establish a correspondingly absurd breakup value for Electric Bond and Share common. This break-up value was industriously exploited to justify higher and higher quotations for the latter issue. In March 1929 attention was called to the fact that the market value of this company’s portfolio was equivalent to about $108 per share (of new stock), against a range of 91 to 97 for its own market quotation. The implication was that Electric Bond and Share stock was “undervalued.” In September 1929 the price had advanced to 184½. It was then computed that the “break-up value” amounted to about 150, “allowing novalue for the company’s supervisory and construction business.” The public did not stop to reflect that a considerable part of this “book value” was based upon an essentially fictitious market quotation for an asset that the company had received
for nothing
only a few years before (as a bonus with American and Foreign Power Second Preferred stock).
    This exploitation of the warrants had a peculiar vitality which made itself felt even in the depth of the depression in 1932–1933. Time having brought its usual revenge, the once dazzling American and Foreign Power Company had trembled on the brink of receivership, as shown by a price of only 15¼ for its 5% bonds. Nevertheless, in November 1933 the highly unsubstantial warrants