Part 17:  Absurdities on Wall St – Red Flags to Watch

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💥 Why This Matters

• Avoid hype cycles: Don’t be swayed by trends or ‘hot stocks’. Dig into the company’s actual financial health, earnings quality, and long-term prospects.

• Avoid excessive debt: Rapid expansion of growth fueled by debt is a major red flag. Scrutinize companies making acquisitions, especially if they involve taking on significant debt or using complex accounting methods to mask the financial impact

• Don’t ignore glaring inconsistencies: Pay attention to red flags like a company consistently paying no income taxes or reporting “record earnings” after years of losses. Free cash flow is typically the truest measure of a company’s health (not earnings)

📝  Introduction

Socrates’ quote emphasizes the humility required for true learning, acknowledging that the more we learn, the more we realize how much we don’t know.

Put another way, it’s very dangerous to assume you know something that you don’t. In a similar vein, Friedrich Nietzsche told us:

“He who has a why to live can bear almost any how”

This quote speaks to the powerful motivation behind seeking knowledge, even when it requires significant sacrifice.

Both quotes remind us the pursuit of wisdom can be challenging and requires sacrifice.

And whilst truth itself can be elusive and multifaceted – our ability to consider multiple perspectives and possibilities, even those that challenge our assumptions, is what we must always strive to do.

Adopting this mindset will serve you well when it comes to investing.

✍️ Lessons from Wall St.

Chapter 17 reminds us of the extreme realities (and absurdities) of Wall Street.

And whilst Graham wrote this text over 50 years ago – there are countless more examples which continue to repeat.

Nothing changes and this time is not different.

Graham dissects four case studies of companies whose dramatic rise and fall on Wall Street offer crucial lessons for investors.

He argues that these extreme cases highlight the dangers of neglecting fundamental analysis, chasing speculative bubbles, and overlooking glaring warning signs which are obvious in financial statements.

The four companies and their respective lessons are:

1. Penn Central: Neglecting financial weakness and overvaluing a declining giant.
2. Ling-Temco-Vought: Unsustainable growth fueled by reckless debt and indiscriminate lending.
3. NVF Corp: A disastrous acquisition driven by questionable accounting practices.
4. AAA Enterprises: Exploiting market hype and “hot issue” frenzy with little substance.

#1. Penn Central Debacle

Penn Central, once the nation’s largest railroad, shocked the financial world with its 1970 bankruptcy.

However, its collapse could have been foreseen through basic security analysis. For example, how does a company report “strong earnings” when it didn’t pay income tax for 11 years? 

• Ignoring Red Flags: Penn Central’s interest coverage ratio fell far short of conservative standards. The company hadn’t paid income taxes in 11 years, a glaring red flag that should have raised questions about its reported earnings

• Overvaluation: Despite its weak financials, Penn Central’s stock traded at a ridiculously high price-to-earnings ratio

• Missed Opportunities: Investors could have exchanged Penn Central bonds for safer utility bonds with the same coupon rates. This simple move would have protected them from the railroad’s subsequent default.

• Creative Accounting: The company’s merger involved a massive special charge hidden in the footnotes, misleading investors about its true financial position

Now whilst Graham didn’t call this specific red flag out – I looked back at the records and could see that Penn Central’s core railroad operations were generating negative cash flow between 1965 and 1970.

This was due to a combination of factors, including declining freight traffic, rising costs, and operational inefficiencies.

In addition, the company increasingly relied on income from its non-railroad subsidiaries, particularly real estate, to offset the losses from its railroad operations. This masked the true extent of the railroad’s financial problems.

Finally, there was the issue of its excessive debt relative to its income (and assets). To finance its operations and diversification efforts, Penn Central resorted to heavy borrowing, which further strained its cash flow.

This ultimately contributed to its bankruptcy in 1970.

#2. Ling-Temco-Vought: An Empire Built on Debt

Ling-Temco-Vought’s rapid expansion and reliance on excessive debt led to its spectacular collapse.

Graham highlights the company’s “empire building” strategy and the role of banks in enabling its unsustainable growth.

• Reckless Expansion: The company’s debt ballooned as it acquired businesses at a breakneck pace. This aggressive growth masked underlying financial weaknesses.

• Misleading Accounting: They manipulated its earnings by shifting charges and reserves into a single bad year to create the illusion of “record earnings” in subsequent years. Always evaluate earnings using a minimum 3 to 4 year average period. This will help smooth out anomalies.

• Overvaluation: The stock price traded at 22x its tangible book value. This disconnect from reality ultimately led to a devastating crash

• Indiscriminate Lending: Banks continued to lend to the company despite its deteriorating financial condition, further fueling its unsustainable growth

The Ling-Temco-Vought case serves as a cautionary tale about the dangers of excessive debt and the importance of responsible lending practices. It highlights the need for investors to be wary of companies pursuing rapid growth through acquisitions fueled by debt.

As an aside, a company which comes to mind today taking on excessive debt is Boeing (BA)

Widely regarded as one of America’s most iconic brands – S&P placed the leading aircraft manufacturer on credit watch with negative implications due to strike by the machinist union (which was recently resolved) – however still increases financial risk for the company.

For example, despite Boeing issuing a significant amount of equity and equity-linked securities to mitigate the financial impact of cash flow deficits (in turn materially diluting existing shareholders) – the negative credit score remains.

Based on Yahoo!Finance, their current trailing 12 month interest rate cover ratio is -2.3x

This means it fails to generate enough operating income to cover its interest expenses.

From mine, Boeing is a higher risk bet. How effectively Boeing manages its debt levels (and diminished cash flow) will be critical in maintaining its investment-grade rating. You can read more here.

#3. NVF Corp: A Takeover Tale Gone Wrong

NVF Corp’s acquisition of Sharon Steel, a company seven times its size, is presented as a prime example of a disastrous takeover.

Graham criticizes the deal’s financial disparities and the use of questionable accounting methods.

• Financial Strain: The acquisition saddled NVF with a massive debt burden, transforming its reported earnings from a profit to a loss

• Accounting Gimmicks: NVF employed unusual accounting entries, such as “deferred debt expense” and “excess of equity over cost of investment,” to obscure the true financial impact of the deal.

• Exploiting Bond Prices: The company exploited the low price of its newly issued bonds to generate tax advantages, a move that further raised concerns about its financial health

• Warrant Mania: The deal involved the issuance of warrants, which quickly exceeded the market value of the underlying stock, highlighting the speculative nature of the transaction

The NVF case demonstrates the risks of aggressive acquisitions that strain a company’s financial resources and rely on questionable accounting practices. It emphasizes the need for investors to scrutinize the financial implications of mergers and acquisitions.

#4. AAA Enterprises: Riding the “Franchising” Wave to Bankruptcy

AAA Enterprises, a small company that capitalized on the “franchising” trend, exemplifies the dangers of market hype and speculative bubbles.

The company traded at an inflated valuation – where brokerage houses ‘pumped’ the stock to investors – driving by commissions.

• Exploiting Market Trends: AAA Enterprises leveraged the popularity of franchising to attract investors, despite having limited financial substance.

• Unrealistic Valuation: The company’s stock price soared to exorbitant levels, driven by speculative frenzy rather than fundamental value (at one point trading at a forward PE more than 115x its earnings)

• Questionable Accounting: The company’s rapid descent into bankruptcy suggests potential accounting irregularities and misleading financial reporting

• Brokerage House Responsibility: The astute investor would challenge the ethical standards of brokerage houses involved in promoting such speculative offerings

Now over the past 20 years – I can think of many examples where the script for “AAA Enterprises” is similar (i.e., a company overhyped on questionable earnings and/or unproven business models).

Three names which quickly come to mind include (not limited to): 

• Theranos (2003-2018): This blood-testing company promised “revolutionary” technology but was later exposed for fraudulent claims and inaccurate test results. The company attracted significant investment (from “educated investors”) – based on hype and a charismatic leader – despite a lack of solid evidence supporting its technology.

• Nikola Corporation (founded 2014): This electric truck maker initially generated excitement with its futuristic designs and ambitious claims. However, it faced scrutiny and investigations regarding its technology and production capabilities, leading to a sharp decline in its stock price. Again, investors failed to do due diligence and bought into the electric vehicle hype. 

• SuperMicro Computer (SMCI): In October 2024, Super Micro’s auditor, Ernst & Young (EY), abruptly resigned. Their resignation raised concerns about potential accounting irregularities and internal control weaknesses within the company. The uncertainty surrounding the company’s financial reporting saw the stock crash ~80%. Anyone observing the sharp decline in cash flow despite reporting “strong earnings” would have raised a red flag. 

To be clear, the list above is not intended to be exhaustive. There are many other similar examples where investors have been fooled by following a hype cycle.

Lucent and Tyco come to mind twenty years ago. In addition, various SPACs (Special Purpose Acquisition Companies) that merged with companies with unproven business models or speculative technologies, experienced rapid price increases followed by significant declines. And last but not least – we saw something very similar with meme stocks such as GameStop (GME) and AMC.

In closing, beware aware of hype cycles and hot stocks. They rarely end well. Investors should practice basic due diligence on the financial metrics outlined above.

 5 Key Takeaways

These examples highlight the importance of fundamental analysis, sound investment principles, and ethical practices in the financial industry.

Put another way, apply critical independent thinking.

By way of example, at the time of writing we’re witnessing another hype cycle regarding artificial intelligence (AI).

And whilst the possibilities of the tech are extremely promising (n.b., I work in the field of GenAI w/Google) – we saw similar the sentiment we saw in 1999 with the internet.

To be clear, there will be companies which will do exceptionally well from AI over the next 10+ years (from chips to platforms to applications).

However, many investors will fall victim to the red flags described in this chapter. To help you avoid the pitfalls – investors should: 

• Prioritize Fundamental Analysis: Focus on a company’s financial health; earnings quality; free cash flow; debt ratios and long-term prospects

• Be Wary of Excessive Debt: A simple rule of thumb to keep out of trouble is to avoid companies with unsustainable debt levels, especially those pursuing rapid growth through acquisitions.

• Scrutinize Accounting Practices: There is a lot of financial ‘wizardry’ with Wall. St – especially with earnings. Earnings are easy to manipulate. However, revenue and free cash flow are not. Pay close attention to a company’s accounting policies.

• Avoid Speculative Bubbles: Don’t get caught up in market hype or invest in companies with inflated valuations based on flimsy premises. It can be very tempting to chase the latest hot trend (‘FOMO’) however resist the urge. 

• Think Critically and Act Independently: Above all else, think for yourself. Continue to ask critical questions.