Value Investing

Rare Benjamin Graham Article From 1919: A Neglected Chain Store Issue

Every so often the internet throws up an undiscovered gem from the world of value investing. The latest offering is a selection of articles written by Benjamin Graham in 1919 for the Magazine of Wall Street.

chain store issue

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These articles cover several topics including analysis by Benjamin Graham on several securities, giving us a fascinating insight into the way the Godfather of value investing analyzed securities and how he looked for value.

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A Neglected Chain Store Issue

One of the articles from 1919 contains an analysis on a so-called 'chain store' issue. The article compares four of the main 'five and ten cent' store groups at the time, McCrory, Kress, Kresge, and Woolworth. Of these four, Graham picks out McCrory for being deeply unloved and overlooked by the rest of the market.

"McCrory is an inactive issue, dealt in “over the counter” only. For this reason, investors generally are but little acquainted with the latter company, their knowledge being restricted to the vague impression that this is a small and none too prosperous enterprise. Let us see to what extent this opinion is justified by the facts."

McCrory was the smallest of the four issues, but it was by far the cheapest. In the article, Graham presents a table showing the gross percentage of 1918 earnings to the market price of the four companies' shares. He highlights that for 1918, "McCrory earned last year 21% on its market price, against only 7.48% in the case of Woolworth. Woolworth was by far the bigger company, which attracted investors to its shares. However, McCrory was by far the cheaper issue. Here's how Graham laid out his valuation breakdown of the two companies:

“We note for example that in 1918 Woolworth's sales were eleven times, and its net profits seventeen times, greater than those of McCrory. For many readers, this would seem conclusive evidence that Woolworth is a much more desirable investment. Yet it is of equal significance that the smaller company has only one-tenth as many shares and that each share is selling at only one-fifth the price of Woolworth common.

In other words, while Woolworth may be earning seventeen times as much as McCrory, its market valuation is fifty times as great. Consequently, McCrory earned last year 21% on its market price, against only 7.48%. in the case of Woolworth. Despite the latter company's enormously greater business, from the standpoint of earning power, McCrory would appear more than twice as attractive at 25 as Woolworth is at 125.”

The dean of Wall Street then goes on to considering McCrory's balance sheet in his valuation calculation:

“These results should be interesting enough to tempt us further into an examination of the tangible asset position of McCrory as compared with its more pretentious rivals...In the first place, it is rather startling to note that McCrory preferred, which goes begging around 92, has actually more tangible assets behind it per share than Woolworth preferred, one of the highest priced and form system in the accompanying graphs.

But to return to McCrory it is indeed astonishing to discover that the tangible asset value per share of this humble common stock is fully as large as that of Woolworth, which sells five times as high. Moreover, if allowance is made for 1918 taxes (which are not provided for in the Woolworth balance sheet), McCrory would actually be found to have more dollars of real assets behind each share of common.

If the very low market price of McCrory is taken into account, its tangible asset position—like its earning power-places it distinctly at the head of the four companies. It is the only one of all the common stocks which is selling for less than the real assets behind it. These represent 160%. of its market price, against only 33% for Woolworth and Kress and 86% for Kresge."

So, McCrory was going cheap, but what were the reasons behind the low share price? Graham speculates that investors are disappointed with the issue because of the absence of a common dividend. "This is an important drawback," he notes, "yet not a fatal defect." The withholding of dividends enabled the company to build up its "uncommonly strong tangible asset position."

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Rather than the lack of dividend income holding back the stock, Graham speculates that the company's current asset position is more likely to be putting investors off from the issue. As sales doubled, McCrory's net current asset position remained stable. All excess surplus earnings were paid back into additional stores and reinvested into a subsidiary. "With sales increasing so much faster than working capital, the company would doubtless find it hard to spare the cash for common dividends," Graham notes.

A similar situation had evolved with a different business several years before:

“One is moved to point out, however, that a very similar situation obtained with regard to S. S. Kresge, less than two years ago. This company's stock was then selling at 80, at which price it appeared a remarkable bargain in view of its exceptionally high earning power and asset backing. But its working capital had failed to keep pace with the rapid expansion of its business and was lower in proportion to sales than that of any of the other chain store systems, McCrory included. Hence the directors were, and still are, compelled to pursue a very conservative dividend policy. It is likely that even the insiders hesitated to buy into this extremely prosperous enterprise because they feared it would be a long time before it could spare the cash for liberal dividends.”

Benjamin Graham goes on to point out other problems with the business. Specifically, despite rapid growth in the top line, the "equally persistent shrinkage" in the net profit per dollar of sales has held back earnings growth.

Net earnings as a percentage of gross profit declined from 7.24% in 1913 to 3.7% in 1918. Nevertheless, what the company lacked in growth, it made up for in stability. " In no year in the past 7 has less than $4 been earned per share of common stock," Graham points out in the article.

A company with a strong balance sheet and stable earnings could be a good investment for the patient investor, Graham concludes:

“McCrory is therefore in a fundamentally sound position, and there are possibilities of a sharp expansion in net profits, dependent upon the capabilities of its management.
...
All things considered, it is difficult to imagine McCrory's being worth less than 25 under any circumstances, while there are good reasons to look forward to seeing its price much higher one of these days. It is a good stock for the patient investor, the kind that usually makes the largest profits and incidentally isn't worried by day to day fluctuations.”

This originally appeared at ValueWalkPremium.com