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

through the ensuing depression, and it threatened to be accepted as the standard practice for stock financing of all kinds of enterprises. But there is good reason to ask the real meaning of a set-up of this kind, first, with respect to what the buyer of the stock gets for his money, and second, with respect to the position occupied by the investment banking houses floating these issues.
    Cost of Management; Three Items. A new investment trust—such as Petroleum Corporation in January 1929—starts with two assets: cash and management. Buyers of the stock at $34 per share were asked to pay for the management in three ways,
viz
.:
    1. By the difference between what the stock cost them and the amount received by the corporation.
    It is true that this difference of $3 per share was paid not to the management but to those underwriting and selling the shares. But from the standpoint of the stock buyer the only justification for paying more forthe stock than the initial cash behind it would lie in his belief that the management was worth the difference.
    2. By the value of the option warrants issued to the organizing interests. These warrants in essence entitled the owners to receive one-third of whatever appreciation might take place in the value of the enterprise over the next five years. (From the 1929 view-point a five-year period gave ample opportunity to participate in the future success of the business.) This block of warrants had a real value, and that value in turn was taken out of the initial value of the common stock.
    The price relationships usually obtaining between stock and warrants suggest that the 1,625,000 warrants would take about one-sixth of the value away from the common stock. On this basis, one-sixth of the $100,750,000 cash originally received by the company would be applicable to the warrants, and five-sixths to the stock.
    3. By the salaries that the officers were to receive, and also by the extra taxes incurred through the use of the corporate form.
    Summarizing the foregoing analysis, we find that buyers of Petroleum Corporation shares were paying the following price for the managerial skill to be applied to the investment of their money:

    The three items together may be said to absorb between 25 and 30% of the amount contributed by the public to the enterprise. By this we mean not merely a deduction of that percentage of future profits but an actual sacrifice of invested
principal
in return for management.
    What Was Received for the Price Paid?
Carrying the study a step farther, let us ask what kind of managerial skill this enterprise was to enjoy? The board of directors consisted of many men prominent in finance, and their judgment on investments was considered well worth having. But two serious limitations on the value of this judgment must here be noted. The first is that the directors were not obligated to devote themselves exclusively or even preponderantly to this enterprise. They were permitted, and seemingly intended, to multiply these activities indefinitely. Common sense would suggest that the value of their expert judgment toPetroleum Corporation would be greatly diminished by the fact that so many other claims were being made upon it at the same time.
    A more obvious limitation appears from the Corporation’s projected activities. It proposed to devote itself to investments in a single field—petroleum. The scope for judgment and analysis was thereby greatly circumscribed. As it turned out, the funds were largely concentrated, first in two related companies—Prairie Pipe Line Company and Prairie Oil and Gas Company—and then in a single successor enterprise (Consolidated Oil Corporation). Thus Petroleum Corporation took on the complexion of a holding company, in which the exercise of managerial skill appears to be reduced to a minimum once the original acquisitions are made. 1
    1 The same logical objection to the payment of a large “managerial bonus,” in the form of option warrants to those organizing a holding company, may be urged against the set-up of Alleghany Corporation and United Corporation.
    We are forced to conclude that financial schemes of the kind illustrated by Petroleum Corporation of America are unsatisfactory from the standpoint of the stock buyer. This is true not only because the total cost to him for management is excessive in relation to the value of the services rendered but also because the cost is not clearly disclosed, being concealed in good