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

given any pretext for bullish excitement. (Whether through hypocrisy or self-deception, brokerage-house customers generally refuse to admit they are merely gambling with ticker quotations and insist upon some ostensible “reason” for their purchases.) Stock dividends and other “favorable developments” of this character supply the desired pretexts, and they have been exploited by the professional market operators, sometimes with the connivance of the corporate officials. The whole thing would be childish if it were not so vicious. The securities analyst should understand how these absurdities of Wall Street come into being, but he would do well to avoid any form of contact with them.
    Litigation
. The tendency of Wall Street to go to extremes is illustrated in the opposite direction by its tremendous dislike of litigation. A lawsuit of any significance casts a damper on the securities affected, and the extent of the decline may be out of all proportion to the merits of the case. Developments of this kind may offer real opportunities to the analyst, though of course they are of a specialized nature. The aspect of broadest importance is that of receivership. Since the undervaluations resulting therefrom are almost always confined to bond issues, we shall discuss this subject later in the chapter in connection with senior securities.
    Example
: A rather striking example of the effect of litigation on common-stock values is afforded by the Reading Company case. In 1913 the United States government brought suit to compel separation of the company’s railroad and coal properties. The stock market, having its own ideas of consistency, considered this move as a dangerous attack on Reading, despite the fact that the segregation would in itself ordinarily be considered as “bullish.” A plan was later agreed upon (in 1921) under which the coal subsidiary’s stock was in effect to be distributed pro rata among the Reading Company’s common and preferred shareholders. This was hailed in turn as a favorable development, although in fact it constituted a victory for the government against the company.
    Some common stockholders, however, objected to the participation of the preferred stock in the coal company “rights.” Suit was brought to restrict these rights to the common stock. Amusingly, but not surprisingly, the effect of this move was to depress the price of Reading common. In logic, the common should have advanced, since, if the suit were successful, there would be more value for the junior shares, and, if it failed (as it did), there would be no less value than before. But the stock market reasoned merely that here was some new litigation and hence Reading common should be “let alone.”
    Situations involving litigation frequently permit the analyst to pursue to advantage his quantitative approach in contrast with the qualitative attitude of security holders in general. Assume that the assets of a bankrupt concern have been turned into cash and there is available for distribution to its bondholders the sum of, say, 50% net. But there is a suit pending, brought by others, to collect a good part of this money. It may be that the action is so far-fetched as to be almost absurd; it may be that it has been defeated in the lower courts, and even on appeal, and that ithas now but a microscopic chance to be heard by the United States Supreme Court. Nevertheless, the mere pendency of this litigation will severely reduce the market value of the bonds. Under the conditions named, they are likely to sell as low as 35 instead of 50 cents on the dollar. The anomaly here is that a remote claim, which the plaintiff can regard as having scarcely any real value to him, is made the equivalent in the market to a heavy liability on the part of the defendant. We thus have a mathematically demonstrable case of undervaluations, and, taking these as a class, they lend themselves exceedingly well to exploitation by the securities analyst.
    Examples
: Island Oil and Transport 8% Notes. In June 1933 these notes were selling at 18. The receiver held a cash fund equivalent to about 45% on the issue, from which were deductible certain fees and allowances, indicating a net distributable balance of about 30 for the notes. The distribution was being delayed by a suit for damages that had been repeatedly unsuccessful in its various legal stages and was now approaching final determination. This suit was exerting an adverse effect upon the