Security Analysis Series: Chapter 40 Summary

“Capitalization Structure”

Chapter Summary

• Graham presents a paradox in this chapter: namely that companies with the same earning power can have different values due to capitalization structure. This is due to the concept of leverage. Leverage refers to the sensitivity of earnings per share to change. Given two companies that have an identical change in earnings, where one sees a greater % change in EPS, that company can be said to be more “levered” than the other. (pg 508).
  • Leverage operates both ways; a decrease or an increase in earnings will affect the more levered company’s EPS. (pg 508).
• The optimum capital structure according to Graham:
  • “…includes senior securities to the extent that they may safely be issued and bought for investment.” (pg 509).
    • What Graham means by this is that his standard of “investment basis” selection applied to the debt in the capitalization structure of a company. A company should be as levered as possible, but only to the maximum level where the issued debt is an investment, rather than speculation, IE it is well covered by assets, the interest payments are sustainable in regards to earnings, etc. (pg 509).
    • It is also important to note that a higher % coupon rate can lead to rejection by an investor due to poor interest coverage. However Graham points out that it is rediculous to accept one bond at 4% because it has 2x coverage, and reject another 6% bond because it has slightly less than 2x coverage. It is clear that rejecting a bond because it pays a higher rate is fallacious. Graham advises that “the minimum margin of safety behind bond issues must be set high enough” to avoid the appearance of safety achieved by a lower rate.  (pg 511).
• Highly levered companies may not be bought on an absolute investment basis, but rather on an investment basis with a degree of “speculative advantage” attached. These companies sell at high prices relative to their value in booms, but in depressions, there is a large degree of undervaluation. These issues bought on a depression basis “can advance much further than they can decline”. (pg 513).
• There exists other ways a company’s leverage can be influenced apart from capital structure. Fixed expenses eat up a greater % of earnings when earnings are low, depressing EPS; however, when earnings are high, these expenses make up a fraction of a % compared to the low earnings periods. Thus, high amounts of fixed charges such as depreciation can act as leverage for a company. (pg 515).
• A speculatively capitalized company offers shareholders the possibility of benefiting at the expense of the debt holders. “The common stockholder is operating with a little of his own money and with a great deal of the senior security holder’s money”. (pg 517).
• Due to the fact that this benefit only exists when the share price is advancing, Graham suggests only buying highly levered issues when “they are selling at abnormally low levels due to temporarily unfavorable conditions”. (pg 518).
  • The difficulty in this is being able to detect these temporary conditions and low prices, as well as waiting for the conditions to be solved. (pg 518).

Chapter Thoughts and Analysis

• This chapter is perhaps my favourite in the entire book. Graham’s communication of leverage as an influence on earning power, and the speculative advantages when buying levered companies on a depression basis, really gave a profound clarity to these concepts.
• The idea of fixed charges acting as leverage is a concept I hadn’t heard of anywhere before. As he will put forth in the following chapter, this has many applications. Highly capital intensive industries with large fixed charges/outlays (the extractive industries obviously come to mind) will be able to accomplish absolutely explosive growth in an uptrend.
• As Graham pointed out, it seems to be that the main issues with an investment strategy based (partially, as one still must due proper due diligence to find investment grade companies) around depressed industries is opportunity cost. Sure the price may kick at some time in the future, but what investments are we possibly missing out on in the near future? And given the time value of money, will the growth a speculatively levered company enjoys five years down the road outweigh its near-term alternatives?