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

obtains. An exchange can then be considered solely from the standpoint of the respective merits within the given situation; the responsibility for entering into or remaining in the situation need not be assumed by the analyst. In our previous chapters we have considered a number of cases in which relative prices were clearly out of line, permitting authoritative recommendations of exchange. These disparities arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities. Examples of the first type were given in our discussion of price discrepancies involving guaranteed issues in Chap. 17. The price discrepancies between various Interborough Rapid Transit Company issues, discussed in Appendix Note 56 on accompanying CD, and between Brooklyn Union Elevated Railroad 5s and Brooklyn-Manhattan Transit Corporation 6s, referred to in Chap. 2, are other illustrations in this category. 2
    2 The student is invited to consider the price relationships between Pierce Petroleum and Pierce Oil preferred and common in 1929; between Central States Electric Corporation 5½% bonds and North American Company common in 1934; between the common issues of Advance-Rumely Corporation and Allis-Chalmers Manufacturing Company in 1933; between Ventures, Ltd., and Falconbridge Nickel, and between Chesapeake Corporation and Chesapeake and Ohio Railway common stocks in 1939—as examples of disparities arising from ownership by one company of securities in another.
    The illogical price relationships between a senior convertible issue and the common stock, discussed in Chap. 25 on accompanying CD, are examples of opportunities arising from the concentration of speculative interest on the more active junior shares. A different manifestation of the same general tendency is shown by the spread of 7 points existing in August 1933 between the price of American Water Works and Electric Company “free” common and the less active voting trust certificates for the same issue. Such phenomena invite not only direct exchanges but also hedging operations.
    A similar comparison could be made in July 1933 between Southern Railway 5% Noncumulative Preferred, paying no dividend and selling at 49, and the Mobile and Ohio Stock Trust Certificates, which were an obligation of the same road, bearing a perpetual guaranty of a 4% dividend and selling concurrently at 39¾. Even if the preferred dividend had been immediately resumed and continued without interruption, the yieldthereon would have been no higher than that obtainable from the senior fixed-interest obligation. (In 1939 Southern Railway Preferred, still paying no dividend, sold at 35 against a price of about 40 for the Mobile and Ohio 4% certificates. At these prices the advantage still appeared clearly on the side of the guaranteed issue.)
    Other and Less Certain Discrepancies
. In the foregoing examples the aberrations are mathematically demonstrable. There is a larger class of disparities between senior and junior securities that may not be proved quite so conclusively but are sufficiently certain for practical purposes. As an example of these, consider Colorado Industrial Company 5s, due August 1, 1934, guaranteed by Colorado Fuel and Iron Company, which in May 1933 sold at 43, while the Colorado Fuel and Iron 8% Preferred, paying no dividend, sold at 45. The bond issue had to be paid off in full within 14 months’ time, or else the preferred stock was faced with the possibility of complete extinction through receivership. In order that the preferred stock might prove more valuable than the bonds bought at the same price, it would be necessary not only that the bonds be paid off at par in little over a year but that preferred dividends be resumed and back dividends discharged within that short time. This was almost, if not quite, inconceivable.
    In comparing nonconvertible preferred stocks with common stocks of the same company, we find the same tendency for the latter to sell too high, relatively, when both issues are on a speculative basis. Comparisons of this kind can be safely drawn, however, only when the preferred stock bears cumulative dividends. (The reason for this restriction should be clear from our detailed discussion of the disabilities of noncumulative issues in Chap. 15.) A price of 10 for American and Foreign