I Care Oct'08

Portfolio Management Services

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October2008

Market Commentary The month of September has been historical for the global financial world. During this month, we witnessed the bailout of AIG by the US Government, the collapse & sale of parts of Lehman Brothers to different players, the takeover of Merrill Lynch by Bank of America, the collapse of Washington Mutual & its buy out by JP Morgan, the takeover of Wachovia Bank by Citigroup and finally the conversion of Goldman Sachs & Morgan Stanley into bank holding companies. Then at the fag end of the month, the US lawmakers surprisingly rejected a $700bn bailout plan for the financial industry in the US. The House voted 228-205 to reject the bailout bill, which, would have authorized the Treasury Department to purchase broken mortgage backed bonds from banks with the goal of jump-starting stalled capital markets. At the time of writing, the US President has been consulting with economic advisors, including the Fed Reserve Chief, to consider the next move. In Europe too, governments went into action to avoid crisis.Three governments, namely of Belgium, the Netherlands and Luxembourg, agreed to inject $16.4bn into Fortis, the banking and insurance company. Fortis will sell parts of ABN Amro it bought last year to Dutch rival ING, in a deal expected to be finalised within two weeks. BSE Indices

In Britain, mortgage lender Bradford & Bingley became the second British bank to be taken under the government’s wing since the crisis began last year. Spanish bank Santander will buy its retail deposits and branch network. As these events kept unfolding one after the other, the equity indices world over became jittery and closed the month in the red, with DJIA, FTSE, CAC and DAX all downwards of 6%. Amongst the BRIC nations, China surprisingly did better after falling continuously for last so many months. Russia, India and Brazil did badly. In fact trading was affected for few days in Russia, following the liquidity crisis. Crude oil also saw wild swings first falling to $92 / bbl then jumping to a high of $127 at the end of settlement and again cooling off to $98. Likewise, most commodity prices have eased off recently. Domestically, the worst sectoral indices were Realty (-30%), Metals (-27%) and Consumer Durables (-23%) respectively. FMCG, Oil & Gas, and PSU indices fared better though they also closed down. Liquidity has dried up especially in the mid-caps where foreign institutions have to manage block deals to raise cash. FII flows and the country’s current account were both negative. As a International

3o-Sep-08

Monthly

SENSEX BSE-100 BSE-200 BSE-500 BSE MID-CAP BSE SMALL-CAP BSE-CG BSE-CD BSE-FMCG BSE-HC BSE-IT BSE-PSU BSE-TECK BSE BANKEX BSE AUTO BSE METALS BSE OIL & GAS BSE REALTY BSE POWER S&P CNX NIFTY

12,860.43 6,691.57 1,555.70 4,897.59 4,798.29 5,577.47 10,581.13 2,929.18 2,160.76 3,672.18 3,095.08 6,246.03 2,545.91 6,478.85 3,674.98 8,992.06 9,039.28 3,508.77 2,260.27 3,921.20

-11.7% -12.2% -12.7% -13.0% -16.4% -19.1% -11.0% -23.7% -2.5% -14.8% -22.0% -7.4% -17.2% -7.6% -8.2% -27.2% -6.4% -29.8% -13.2% -10.1%

Institutional activity

YTD -36.6% -40.0% -41.4% -43.0% -51.0% -58.2% -46.4% -57.9% -6.9% -16.9% -31.7% -40.3% -36.6% -43.3% -35.2% -55.1% -32.0% -72.4% -50.3% -36.1%

(Rs cr)

Category

Monthly

FIIs Mutual Funds

(8,665.1) 1,887.4

(20,482.5) (4,265.0)

492

(1,342)

YTD: From December 31, 2007

YTD

INDEX

30-Sep-08

Monthly

YTD

DJ INDU AVERAGE FTSE 100 EOD IDX XETRA DAX PF CAC 40 INDEX NIKKEI 225 INDEX

10,850.66 4,902.45 5,831.02 4,032.10 11,259.86

-6.0% -13.0% -9.2% -10.0% -13.9%

-18.2% -24.3% -27.7% -28.2% -26.4%

49,541.3 2,408.9 12,860.4 1,211.84

-11.0% -4.3% -11.7% -26.4%

-22.5% -56.4% -36.6% -47.1%

BVSP BOVESPA IND SSE A SHARE IDX SENSEX RTS INDEX

YTD: From December 31, 2007 close Nasdaq 2,426 Dow Jones 12,463

Others NAME

GOLD SILVER NYMEX LIGHT CRUDE INR/USD ALUMINIUM COPPER LEAD ZINC NICKEL

Closing 879.75 12.14 101.56 46.96 2,391.00 6,460.50 1,806.50 1,664.50 16,165.00

(0.3) 2.0 Monthly

YTD

6.0% -10.6% -12.0% 6.8% -10.3% -14.5% -8.3% -7.1% -19.8%

5.6% -17.8% 5.8% 19.1% 1.4% -2.7% -29.0% -29.3% -37.9%

Portfolio Management Services

INDEX

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Portfolio Management Services result, the currency has depreciated by 6.8% in the last month. On the positive front, prices of crude oil and most commodities have slipped, though they continue to see wild swings, inflation on sequential basis is steady with the possibility of it falling to single digit by middle of next year and chances that the tight monetary measures may be eased have increased. Equity valuations too have become attractive, although the risks of earnings downgrades remain high and some may argue that we are still expensive when compared to other markets. Below we have given the trend in Sensex P/E multiple for the last three years and estimates for the coming two years. Also we have given comparative multiples for the developed and emerging markets.

BSE Sensex Estimates Y/E March BSE Sensex P/E (x)

2006

2007

2008

2009F

2010F

11,280 13,072 15,644 12,860 12,860 21.6 19.2 18.4 12.9 10.6

Relative Valuations INDEX

PE1

PE2

Change (YTD)

DJ INDU AVERAGE

11.6

10.4

(18.2)

FTSE 100 EOD IDX

8.3

7.9

(24.3)

XETRA DAX PF CAC 40 INDEX

10.8 8.9

9.2 8.2

(27.7) (28.2)

NIKKEI 225 INDEX

14.0

13.0

(26.4)

8.5

7.0

(28.0)

SSE A SHARE IDX

13.8

11.3

(56.4)

BSE-500 RTS INDEX

11.7 3.5

10.2 3.1

(43.0) (47.1)

BVSP BOVESPA IND

Typically a EPC contract in power segment can be split into two - 1) BTG (boiler, turbine and generator) which forms 60% of the EPC value and 2) BoP (balance of power) which forms the remaining 40% of the contract value. Both the two large projects which BGR has won include BTG which will yield margins of 3-5%. The typical margins in BoP is 10-12%. The major competition is from larger players like L&T, BHEL, Tata Projects and Reliance Infrastructure. BGR has focussed on state generation companies and electricity board where it has not seen slowdown. However, there is a slowdown in IPP sector. Considering its order backlog we expect the company to register topline growth of 45% for the coming two years. With the inclusion of BTG (essentially trading) in topline the overall margins will come down. The bottomline should grow upwards of 35%. The stock is attractively priced at current levels.

Vakrangee (CMP: Rs139.20 ; PE1: 3.7x) Vakrangee Sofware is one of the leading players in document management services (DMS) and printing management services (PMS) segments in the country with more than 15 years of experience in digitizing critical documents of various government organisations like land records in UP, electoral rolls for Election Commission, documents for 22 offices of ROC (Registrar of Company). In FY08 it diversified its customer base by serving private companies in BFSI and telecom sectors. Last fiscal the split between Government & private, DMS & PMS and annuity & non-annuity was 63:37, 55:45 and 66:34 respectively. Vakrangee has no borrowings and has been generating enough cash to take care of its expansion plans. It has order book of Rs325cr to be executed in the current fiscal. We estimate the company to grow its topline by 50% for the coming two years and maintain net profit margins between 18-20%. We find its stock attractively priced at current levels.

Vakrangee - Business wise revenues Y/E March

Corporate Notes BGR Energy (CMP: Rs239.15 ; PE1: 12.3x) The two large orders 1) from TNEB for 600MW unit at Mettur valued at Rs3100cr and 2) for Kalisindh from RRVUNL for 2x600MW power plants valued at Rs4900cr have pulled up the order backlog at Chennai based BGR Energy & Systems to Rs11,000cr. The company is essentially into balance of plant segment with in-house capabilities in design, civil and mechanical engineering services for power plants consisting of 20-25 packages like ash & coal handling, water treatment, cooling towers and air-cooled condensers. It outsources electricals (substations), controls and instrumentation to international players. BGR originally started as a joint venture between GEA Energietechnik GmBH, Germany and B G Raghupathy in 1985. After the collaboration period the Indian promoters bought out foreign partner’s stake. The company came with an IPO in Dec-07. October 2008

Government Private Total DMS PMS Total Annuity Non-annuity Total

2006

2007

2008

100.0% 0.0% 100.0% 68.6% 31.4% 100.0% 38.5% 61.5% 100.0%

100.0% 0.0% 100.0% 75.9% 24.1% 100.0% 44.8% 55.2% 100.0%

62.9% 37.1% 100.0% 55.4% 44.6% 100.0% 65.6% 34.4% 100.0%

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Engineers India Curent Price

Company Report Rs560.00

Indices Sensex Nifty

12860.43 3921.20

BSE Code NSE Code Bloomberg Reuters

532178 ENGINERSIN ENGR IN ENGI.BO

Stock Data Share O/S Market Cap 52 Wk H/L (Rs) Av. Daily Vol Free Float (%)

56.16mn Rs32.29bn 1284/425 5,000 9.6%

Shareholding Pattern

Public & Others 3% Promoters 91%

FIIs 1% MF 5%

Summary Established in 1965 to provide engineering and technical services for petroleum refineries and petrochemicals industry, Engineers India (EIL) has extended its services to the following sectors - petroleum, gas pipelines, offshore structures & platforms, non-ferrous metal industry and infrastructure. There has been increased activities in the oil & gas space in the recent past and the momentum is likely to be maintained going forward. The future oil & gas needs call for an investment of $10trillion by the year 2030 according to International Energy Agency. Domestically addition of 91mn TPA in refining capacity and 2mn TPA of ethylene cracker is anticipated in the XI plan. EIL bagged Rs3202cr of orders last fiscal taking its order backlog to Rs5000cr. We expect the company to show growth upwards of 25% for the coming 2 years both in revenues and net profits. EIL is debt free, making good margins and return on capital, consistently generating free cash flows for the last few years and has cash & equivalents of Rs223 per share. Valuations are very attractive. Good order intake and backlog: EIL secured an all time high business totalling Rs3202cr during FY08 compared to Rs1916cr during FY07 registering growth of 67%. This was primarily on account of highest ever new business of Rs1827cr up 96% from the consultancy services in the domestic market. Add to this an contract for Rs1111cr from Chennai Petroleum on an open book estimate basis (convertible into lumpsum turnkey or LSTK) for turnkey execution of deisel hydrotreater and NHT/ISOM units as part of the Euro 4 quality upgradation project under implementation. In the overseas market an overall volume of new business of Rs264cr was secured mainly from UAE and Algeria. The total order book at the end of year is Rs5000cr approximately which has doubled over the previous year. Diversification: With a vision to be a world class globally competitive EPC and total solutions consultancy organisation EIL has closely looked at diversification avenues based on its strength in design, engineering and project management. After successfully

Key Financials EIL Vs Sensex 250 200 150 100

Engineers India

Aug-08

Jun-08

Apr-08

Feb-08

Dec-07

Oct-07

50

BSE-Sensex

Y/E March (Rs cr) Revenues Growth PAT1 Growth EPS (Rs) P/E (x) P/B (x) P/S (x) EV/EBITDA (x) OPM Tax rate NPM Receivables Inventories D/E ROE ROCE Price

2007 571.1 -27.8% 143.0 3.1% 25.5 17.8 5.1 4.5 13.2 19.4% -28.8% 25.0% 136 12 14.4% 10.4% 452.55

2008 737.8 29.2% 194.6 36.1% 34.7 19.2 6.1 5.1 13.9 22.9% -32.9% 26.4% 93 15 17.8% 14.5% 666.60

2009 F 1,068.4 44.8% 273.6 40.6% 48.7 11.8 6.8 3.0 6.2 23.0% -32.6% 25.6% 74 17 22.4% 19.1% 560.00

2010 F 1,442.3 35.0% 372.1 36.0% 66.2 8.7 7.3 2.2 3.4 23.0% -32.6% 25.8% 76 18 26.7% 22.9% 560.00

Source: Company & Religare PMS

October 2008

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Portfolio Management Services diverifying into offering services to non-ferrous metals industry, it has extended its services to infrastructure sector which covers urban water management, airport modernisation, sports facilities etc. Currently it has order book of Rs150cr in metals and Rs160cr in infrastructure space. These include alumina refinery project of JSW Alumina, expansion projects of NALCO, Yamuna Action Plan, sport venues for Commonwealth Games 2010, strategic crude oil storages at 3 locations etc. Focus on Technology: EIL continues to lay emphasis on the role of R&D in the consolidation of existing capabilities, development of new technologies, processes, improvement in efficiencies and knowledge management systems. It plans to carry out studies on coal/coke gasification and gas clean up in association with BPCL R&D and has also been assisting Oil India in evaluation of pilot plant studies on Direct Coal Liquefaction. Outlook:

Risks factor: Slow down or delay in the investment demand for the company’s services. Most of the customers are PSU oil refining and marketing companies which have cash flow constraints due to underrecoveries and subsidies. Attraction and retention of skilled engineers within the company. Low floating stock and lack of liquidity has resulted into lower valuations.

Quarterly Income Statement

World’s energy requirements are growing rapidly. According to The World Economic Outlook 2007 predictions world energy needs would grow by 55% from 11.4bn TOE (Tonnes of Oil and Oil Equivalents) to 17.7bn TOE during 2005-2030. India and China alone are expected to account for 45% of this increase. This calls for an investment of USD10trillion by the year 2030 according to International Energy Agency.

Quarter to end (Rscr)

Almost all refiners in the country are investing more in capacity expansion and fuel up-gradation projects. Addition of 91mn TPA in refining capacity during XI Plan and over 2.0mn TPA Ethylene Cracker in petrochemicals sector is on the anvil.

Operating Profits

To participate increasingly in EPC/LSTK projects in oil & gas and infrastructure sectors both in India and overseas EIL has pursued setting up joint ventures 1) with Tata Projects called TEIL Projects for undertaking EPC projects for hydrocarbon, power and other sectors and 2) with Tecnimont SPA, Italy for executing EPC projects in UAE. While TEIL has already been incorporated, the latter venture has been approved by GOI and the process of incorporation has been set in motion. Based on the order backlog of Rs5000cr and ongoing execution EIL will cross FY07 revenues of Rs571cr by the middle of this fiscal itself.

Non-recurring

EIL bagged Rs3202cr of orders last fiscal taking its order backlog to Rs5000cr. We expect the company to show growth upwards of 25% for the coming 2 years both in revenues and net profits. EIL is debt free, making good margins and return on capital, consistently generating free cash flows for the last few years and has cash & equivalents of Rs223 per share. Valuations are very attractive.

October 2008

Revenues

Growth Expenditure

2007 09 166.99

2007 12 177.45

2008 03 242.82

2008 06 252.44

28.0%

35.3%

49.2%

67.7%

-120.09

-128.79

-197.63

-209.21

Employee Expenses

-78.72

-78.13

-87.7

-93.8

Other Expenses

-41.37

-50.66

-109.93

-115.41

48.66

45.19

43.23

37.3% 224.4%

54.3%

Growth Depreciation

46.9 44.1% -3.7

-2.23

-2.76

-2.04

0

0

-0.03

0

Other Income

29.93

28.82

44.95

34.35

PBT

73.13

75.25

87.35

75.54

-28.58

-22.18

-25.79

-30.19

5.7

-2.16

-4.13

5.94

Interest

Tax - Current Tax - Deferred Tax - FBT PAT1

Growth PAT2

Growth Equity shares o/s cr EPS (Rs) OPM P/E CLOSE"

-0.65

-0.66

-0.75

-0.66

49.6

50.25

56.68

50.63

51.4%

26.0%

33.3%

33.0%

0.04

0.05

19.86

0

49.64

50.3

76.54

50.63

46.9%

22.9%

28.6%

32.9%

5.62

5.62

5.62

5.62

8.8

8.9

10.1

9.0

28.1%

27.4%

18.6%

17.1%

20.0

29.8

19.2

13.7

606.05

956.85

666.60

504.15

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Balance Sheet

Income statement Y/E March (Rscr)

2007

2008

2009 F

2010 F

Y/E March (Rscr)

571.1

737.8

1,068.4

1,442.3

Current assets of which

Growth

-27.8%

29.2%

44.8%

35.0%

Expenditure

(460.1)

(569.0)

(823.1)

(1,111.2)

Employee Expenses

(247.5)

(327.4)

(455.5)

(615.0)

Inventories

16.1

31.9

46.2

62.4

Other Expenses

(212.6)

(241.6)

(367.6)

(496.3)

Loans & advances

279.8

362.0

524.3

707.8

Investments

137.4

146.8

156.8

166.8

Revenues

Operating Profits

2007

2008

2009 F

2010 F

1,437.5

1,823.1

2,389.6

3,050.5

Cash & bank balance

941.4

1,252.6

1,563.4

1,935.1

Receivables

200.2

176.6

255.7

345.2

111.0

168.8

245.3

331.1

-22.6%

52.0%

45.3%

35.0%

Depreciation

(8.3)

(10.3)

(11.9)

(12.0)

Interest

(0.1)

(0.0)

(0.0)

(0.1)

Other Income

102.0

135.5

178.1

240.5

Net Block

39.7

50.4

45.0

38.0

PBT

204.6

293.9

411.5

559.5

Net deferred tax assets

82.4

95.9

100.0

120.0

Tax - Current

(86.5)

(101.2)

(139.4)

(189.8)

0.7

0.4

-

-

Tax - Deferred

27.6

4.6

5.1

7.2

1,697.7

2,116.6

2,691.4

3,375.3

Tax - FBT

(2.8)

(2.7)

(3.6)

(4.9)

PAT1

143.0

194.6

273.6

372.1

666.2

964.5

1,396.8

1,885.7

Growth

3.1%

36.1%

40.6%

36.0%

20.0

20.0

-

-

Growth

Non-recurring

Gross Block Acc Depreciation CWIP

Miscellaneous Exp Total assets Current liabilities of which

1.4

3.5

5.0

5.0

520.8

797.3

1,154.7

1,558.8

167.2

242.1

326.9

-

-

-

-

1,031.5

1,152.1

1,294.6

1,489.6

56.2

56.2

56.2

56.2

975.4

1,095.9

1,238.4

1,433.4

1,697.7

2,116.6

2,691.4

3,375.3

2008

2009 F

2010 F

214.6

273.6

372.1

9.4%

31.6%

27.5%

36.0%

Dividends

(53.4)

(61.8)

(67.4)

(73.0)

Equity

DivTax

(8.5)

(10.3)

(11.2)

(12.2)

Reserves & Surplus

DPS

9.50

11.00

12.00

13.00

Total liabilities & Equity

Borrowings Shareholders' funds

Free Cash Flow To Firm

Ratios

BV (Rs)

168.1 (135.2)

145.4

163.0

DPS (Rs)

163.1 (123.1)

Provisions

Growth

EPS (Rs)

158.1 (111.2)

CL

PAT2

Y/E March

144.7 (106.4)

Y/E March (Rs cr)

2007

2008

2009F

2010F

25.5

34.7

48.7

66.2

EBIT EBIT margins

9.5

11.0

12.0

13.0

183.7

205.1

230.5

265.2

Effective tax rate EBIT * (1-tax rate)

Valuations

2007 102.7

158.4

233.4

319.1

18.0%

21.5%

21.8%

22.1%

-30.1%

-33.8%

-33.5%

-33.5%

71.8

104.9

155.2

212.2

P/E (x)

17.8

19.2

11.8

8.7

NCC

P/B (x)

5.1

6.1

6.8

7.3

WCInv

P/S (x)

4.5

5.1

3.0

2.2

(Inc)/Dec in receivables

23.7

3.4

(Inc)/Dec in inventories

(15.9)

EV/EBITDA (x)

13.2

13.9

6.2

Operating/Returns

(Inc)/Dec in loans & adv.

OPM

Inc/(Dec) in payables

Tax rate NPM Receivables (Days)

19.4%

22.9%

23.0%

23.0%

-28.8%

-32.9%

-32.6%

-32.6%

FCInv

25.0%

26.4%

25.6%

25.8%

FCFF

136

93

74

76

Inventories (Days)

12

15

17

18

Interest coverage

(1,704)

(5,969)

(6,749)

(6,671)

D/E

-

-

-

-

ROE

14.4%

17.8%

22.4%

26.7%

ROCE

10.4%

14.5%

19.1%

22.9%

Price

452.55

666.60

560.00

560.00

October 2008

35.9

14.9

17.0

19.2

(239.0)

42.6

143.1

154.3

(79.1)

(89.5)

(103.5)

(14.3)

(16.2)

(18.7)

(82.2)

(162.3)

(183.5)

(212.3)

(164.7)

298.3

432.3

488.9

(7.2)

(15.5)

(6.5)

(5.0)

(138.6)

147.0

308.8

380.7

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Investment wisdom Current Problems in Security Analysis Lecture No.10 by Benjamin Graham... In this issue of Investment Wisdom we have covered one of the lectures given by Mr. Benjamin Graham on the series entitled Current Problems in Security Analysis presented at the New York Institute of Finance from September 1946 to Februrary 1947. The last lecture sheds light on speculation in relation to security analysis and tries to bring out some less obvious aspects of this important element in finance. The two main points he made were 1) speculative elements are of some importance in nearly all the work of the security analyst, and that the over-all weight and significance of speculation has been growing over the past thirty years. 2) there is a real difference between intelligent and unintelligent speculation, and that the methods of security analysis may often be of value in distinguishing between the two kinds of speculation. So to begin with what do we mean by speculation? There is a chapter in Graham’s book Security Analysis which is devoted to the distinctions between investment and speculation. “An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Speculative operations are all concerned with changes in price. In some cases the emphasis is on price changes alone, and in other cases the emphasis is on changes in value which are expected to give rise to changes in price. This is a rather important classification of speculative operations. It is easy to give examples. If at the beginning of 1946 a person bought U.S. Steel at around 80, chiefly because he believed that in the latter part of bull markets the steel stocks tend to have a substantial move, that would clearly be a speculative operation grounded primarily on an opinion as to price changes, and without any particular reference to value. On the other hand, a person who bought Standard Gas and Electric, $4 preferred, sometime in 1945, at a low price, -say at four dollars a share -- because he thought the plan which provided for its extinction was likely to be changed, was speculating undoubtedly. But there his motive was related to an analysis of value -- or rather to an expected change of value -- which, as it happened, was realized spectacularly. The chapter on speculation and investment covers discussion on the concept of the speculative component in a price. A security might sell at a price which reflected in part its investment value and in part an element which should be called speculative. The example the authors gave back in 1939-1940, with considerable trepidation, was that of General Electric. They intentionally picked out the highestgrade investment issue to illustrate the element of speculation existing in it. Of the price of $38, which it averaged in 1939, the analyst might conclude that about October 2008

$25 a share represented the investment component and as much as $13 a share represented the speculative component. Hence in this very high-grade issue about onethird of the average price in a more or less average market represents a speculative appraisal. That example, which showed how considerable was the speculative component in investment securities is pretty typical of security value developments since World War I. It justifies and explains the first point that speculative elements have become more and more important in the work of an analyst. “I think only people who have been in Wall Street for a great many years can appreciate the change in the status of investment in common stocks that took place in the last generation, and the extent to which speculative considerations have obtruded themselves in all common stocks. When I came down to the Street in 1914, an investment issue was not regarded as speculative, and it wasn’t speculative.” Its price was based primarily upon an established dividend. It fluctuated relatively little in ordinary years. And even in years of considerable market and business changes the price of investment issues did not go through very wide fluctuations. It was quite possible for the investor, if he wished, to disregard price changes completely, considering only the soundness and dependability of his dividend return, and let it go at that -- perhaps every now and then subjecting his issue to a prudent scrutiny. The problem is not whether price changes should be disregarded but rather in what way can the investor and the security analyst deal intelligently with the price changes which take place. In the case of General Electric a considerable portion of the price in 1939 reflected a speculative component. That arises from the fact that investors have been willing to pay so much for so-called quality, and so much for so-called future prospects, on the average, that they have themselves introduced serious speculative elements into common stock valuations. These elements are bound to create fluctuations in their own attitude, because quality and prospects are psychological factors. The dividend, of course, is not a psychological factor; it is more or less of a fixed datum. Matters of prospects and quality are subject to wide changes in the psychological attitude of the people who buy and sell stocks. Thus we find that General Electric will vary over a price range almost as wide as that of any secondary stock belonging in more or less the same price class. A very considerable part of the price of General Electric must be regarded as speculative and perhaps temporary. On the second point, which relates to the analyst’s role in distinguishing intelligent from unintelligent speculation, Graham picked out four low-price securities, which would illustrate the different kinds of results which an analyst may get from dealing with primarily speculative securities. These are, on the one hand, Allegheny Corp. Common, which sold at the end of the month at five, and Graham-Paige Common, which sold at five; and, on the other hand, 6

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Portfolio Management Services General Shareholdings, which sold at four, and Electric Bond and Share six dollars Preferred “Stubs”, which could be bought at the equivalent of three. When we first look at these securities, they all seem pretty much the same -namely, four speculative issues. But a deeper examination by a security analyst would reveal a quite different picture in the two pairs of cases. In the case of General Shareholdings we have the following: This is the common stock of an investment company, which has $21.5-million of total assets, with senior claims of $12-million, and a balance of about $9.5-million for the common. The common is selling for $6,400,000 in the market. That means that in General Shareholdings you have both a market discount from the apparent present value of the stock and an opportunity to participate in a highly leveraged situation. For if you pay $6.4-million of the gross asset value; and consequently every ten per cent of increase in total asset value would mean a 30 per cent increase in the book value of the common. Furthermore, you are practically immune from any danger of serious corporate trouble; because the greater portion of the senior securities -- in fact, five-sixths of it -- is represented by a preferred stock on which dividends do not have to be paid and on which there is no maturity date. Consequently, in the General Shareholdings case, you have that typically attractive speculative combination of (a) a low-price “ticket of entry” into a fairly large situation; and (b) instead of paying more than the mathematical value of your ticket, you are paying less; and (c) if you assume that wide fluctuations are likely to occur in both directions over the years, you stand to gain more than you can lose from these fluctuations. By contrast, if you go to Allegheny Corporation at five, although it seems at first to be a somewhat similar situation -- namely an interest in an investment company portfolio -- you find the mathematical picture completely different. At the end of 1945 the company had about $85million of assets, and against it there were $125-million claims in the form of bonds and preferred stocks, including unpaid dividends. Thus the common stock was about $40million “under water.” Yet at five you would be paying $22-million for your right to participate in any improved value for the $85-million of assets, -- after the prior claims were satisfied. The security analyst would say that there is plenty of leverage in that situation, of course; but you are paying so much for it, and you are so far removed from an actual realizable profit, that it would be an unintelligent speculation. The fact of the matter is you would need a 70% increase in the value of the Allegheny portfolio merely to be even with the market price of the common as far as asset value coverage is concerned. In the case of General Shareholdings, if you had a 70% increase in the value of its portfolio, you would have an asset value of about $15 a share for the common, as against a market price of around $4. Thus, from the analytical standpoint, while Allegheny and General Shareholdings represent approximately the same general picture, there is a very wide quantitative disparity between the two. One turns out to be an intelligent and the other an unintelligent speculation. Passing now to Graham-Paige at $5, we find another type of situation. Here the public is paying about $24-million for a common stock which October 2008

represents about $8-million of asset value, most of which is in Kaiser-Fraser stock. This you can buy if you want in the open market, instead of having to pay three times as much for it. The rest of the price represents an interest in $3million of assets in the farm equipment business -- which may prove profitable, as any business may be profitable. The only weakness to that is that there is no record of profitable operations here, and you are paying a great many millions of dollars merely for some possibilities. That, in turn, would be regarded as an unintelligent speculation by the security analyst. Let us move on now to the Electric Bond and Share Stubs. They represent what you would have left if you had bought Electric Bond and Share Preferred at $73 yesterday and had then received $70 a share that is now to be distributed. What remains is an interest in a possible $10 payment, your claim to which is to be adjudicated by the SEC and the courts. That $10 represents the premium above par to which Electric Bond and Share Preferred would be entitled if it were called for redemption. The question to be decided is whether the call price, the par value, or some figure in between should govern in this case. It should be obvious that that is a speculative situation. You may get $10 a share out of it for your $3, and you may get nothing at all, or you may get something in between. But it is not a speculative operation that eludes the techniques of the security analyst. He has means of examining into the merits of the case and forming an opinion based upon his skill, his experience, and the analogies which he can find in other public utility dissolutions. If we were to assume that the Electric Bond and Share Stubs have a 50-50 chance of getting the $10 premium, then he would conclude that at $3 a share they are an intelligent speculation. For the mathematics indicates that, in several such operations, you would make more than you would lose in the aggregate. These examples lead us, therefore, to a mathematical or statistical formulation of the relationship between intelligent speculation investment. The two, actually, are rather closely allied. Intelligent speculation presupposes at least that the mathematical possibilities are not against the speculation, basing the measurement of these odds on experience and the careful weighing of relevant facts. This would apply for example, to the purchase of common stocks at anywhere within the range of value that we find by our appraisal method. Earlier it was concluded that American Radiator was apparently worth between $15 and $18 a share. If we assume that that job was well done, we could draw these conclusions. The investment value of American Radiator is about $15; between 15 and 18 you would be embarking on what might be called an intelligent speculation, because it would be justified by your appraisal of the speculative factors in the case. If you went beyond the top range of $18 you would be going over into the field of unintelligent speculation. If the probabilities, as measure by our mathematical test, are definitely in favor of the speculation, then we can transform these separate intelligent speculations into investment by the simple device of diversification. For real diversification; you must be sure that the factors that make for success or failure differ in one case from another... 7

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