I saw a post not all that long ago about Buffett’s purchase of a Cooperage in 1951. It inspired me to drag my copy of Intelligent Investor from the attic, and have a little dig into it. I will refer to the 4th revised edition, published 1973.
Chapter 18 was “A Comparison of Eight Pairs of Companies”. Page 250 looked at pair number 2: Air Products and chemicals (“Products”) against Air Reduction Co. (“Reduction”). Both companies were in similar industries, with Products being in the “industrial and medical gases, etc.” sector, and Reduction being in the “industrial gases and equipment; chemicals” sector.
I am going to show an extract from his table of statistics of 1969.
Products Reduction
Mkt value of common $231m $185m
Sales $221.5m $487.6m
Net Income $13.6m $20.3m
P/E 16.5 9.1
PBV 165% 75%
Dividend yield 0.5% 4.9%
Net/Sales 6.2% 4.3%
ROE 11.0% 8.2%
Growth in per-share earnings
1969 vs 1964 +59% +19%
1969 vs 1959 +362% decrease
Here’s what Graham wrote:
Products is a new company that Reduction, and in 1969 had less that half of the other’s volume. Nonetheless its equity issues sold for 25% more in aggregate than Air Reduction’s stock … the reason can be found both in Air Reductions greater profitability and in its stronger growth record. We find here the typical consequences of a better showing of “quality”. Air products sold at 16.5 times its latest earnings against only 9.1 times for Air Reduction. Also Air Products sold well above its asset backing, while Air Reduction could be bought at only 75% of its book value. Air Reduction paid a more liberal dividend; but this may be deemed to reflect the greater desirability for Air Products to retain its earnings. Also, Air Reduction had a more comfortable working-capital position. … If the analyst were called on to choose between the two companies he would have no difficulty in concluding that the prospects of Air Products looked more promising than those of Air Reduction.
Graham sits on the fence as to which one he would choose, but I think he demonstrates some dismissiveness that paying up for quality is the right choice:
Whether this preference is to prove right or wrong is more likely to depend on the unpredictable future than on any demonstrable investment principle. In this instance, Air Reduction appears to belong to a group of important companies in the low-multiple class. … studies … would seem to indicate, that group as a whole is likely to give a better account of itself than the high-multiplier stocks, then Air Reduction should logically be given the preference - but only as part of a diversified operation.
Behind this, Graham seems to have an implicit preference for the cheaper stock. In his “SEQUEL”, subsequent price action would seem to exhonorate that choice:
Air Products stood up better than Air Reduction in the 1970 break, with a decline of 16% against 24%. However, Reduction made a better comeback in early 1971, rising 50% above its 1969 close, against 30% for Products. In this case the low-multiplier issue scored the advantage - for the time being, at least.
In terms of performance, Products had better ROE (Graham calls it Earnings/Book Value), net profit margin and growth. It retained more of its earnings. Perhaps worryingly, Reduction was earning less than it was the decade prior. Reduction was the cheaper stock on both PE and PBV and offered a bigger dividend. I will note that the valuation of Products was not excessive for a quality company.
Let’s fast-forward to today, and see what 20/20 hindsight tell us. What should you have bought?
The answer is pretty unambiguous on this one: Products (ticker code APD). The stock appears to have undergone a number of splits, so I won’t try to calculate the return from the date that Graham wrote his piece. What I can readily give you is the split-adjusted stock performace since April 1984: $5.36 (then) to $234.00 (now, 19 April 2024).
That’s an increase in share price of 4265% over a period of 40 years, 9.9% annualised. That is an excellent performance. For 2023, Revenues were $12.6b, operating expenses $1.11b, net income $2.3b, net profit margin 18.26% (well done!), EPS 11.51, EBITDA $4.01b. Market cap is $52b, PE 22.3, dividend yield 3.03%. It has a 5-year average ROE of 16%, gross margins of around 30%, and operating margins around 23%. Those are really good numbers. Operating income was $2739m, with interest expenses of $178m. So interest expenses look well-covered by income, and the company appears to be in good financial health.
Amazingly, analysts rate it a “strong sell”. The PE is a little high for me. But still, the company has had an amazing performance.
Reduction, not so much. According to a link I found, in January 1971 Products agreed to to buy Reduction for $30m. Reduction’s annual sales at that time was $37m.
Air Reduction's president, George S. Dillon, said he ex pects 1970 after‐tax earnings before extraordinary losses to be down about 15 per cent from 1969. Estimated earn ings from continuing opera tions are expected to be down 10 per cent.
Conclusion If there’s a takeaway from any of this, it’s that just buying cheap is not a good idea. It pays to cough up a little for quality. Sometimes, at least. The fact that profits were down over 10 years proved to be a warning sign. Reduction’s ROE was only so-so, too. What is extraordinary is how much Products was able to grow over many decades. A 9.9% pa capital gain (i.e. excluding dividends) over the 40 years is quite impressive!
Update 2024-04-19 It is possible to trace the share price performance all the way to Graham’s writing, assuming there were no share issues in the interim. APD had a market cap of $231m in 1969, according to Graham. As of today, it is worth about $51.87b. That covers a period of about 55 years, say. that works out at an annualised growth rate in market cap (i.e. still excluding dividends) of 10.3%. Even more impressive.