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October2008

Market Commentary

The month of September has been historical for the global In Britain, mortgage lender Bradford & Bingley became the
financial world. During this month, we witnessed the bailout second British bank to be taken under the government’s
of AIG by the US Government, the collapse & sale of parts wing since the crisis began last year. Spanish bank Santander
of Lehman Brothers to different players, the takeover of will buy its retail deposits and branch network.
Merrill Lynch by Bank of America, the collapse of Washington
Mutual & its buy out by JP Morgan, the takeover of Wachovia As these events kept unfolding one after the other, the equity
Bank by Citigroup and finally the conversion of Goldman indices world over became jittery and closed the month in
Sachs & Morgan Stanley into bank holding companies. Then the red, with DJIA, FTSE, CAC and DAX all downwards of
at the fag end of the month, the US lawmakers surprisingly 6%. Amongst the BRIC nations, China surprisingly did better
rejected a $700bn bailout plan for the financial industry in after falling continuously for last so many months. Russia,
the US. The House voted 228-205 to reject the bailout bill, India and Brazil did badly. In fact trading was affected for
which, would have authorized the Treasury Department to few days in Russia, following the liquidity crisis. Crude oil
purchase broken mortgage backed bonds from banks with also saw wild swings first falling to $92 / bbl then jumping to
the goal of jump-starting stalled capital markets. At the time a high of $127 at the end of settlement and again cooling
of writing, the US President has been consulting with off to $98. Likewise, most commodity prices have eased off
economic advisors, including the Fed Reserve Chief, to recently. Domestically, the worst sectoral indices were Realty
consider the next move. In Europe too, governments went (-30%), Metals (-27%) and Consumer Durables (-23%)
into action to avoid crisis.Three governments, namely of respectively. FMCG, Oil & Gas, and PSU indices fared better
Belgium, the Netherlands and Luxembourg, agreed to inject though they also closed down.
$16.4bn into Fortis, the banking and insurance company.
Liquidity has dried up especially in the mid-caps where foreign
Fortis will sell parts of ABN Amro it bought last year to Dutch
institutions have to manage block deals to raise cash. FII flows
rival ING, in a deal expected to be finalised within two weeks.
and the country’s current account were both negative. As a

BSE Indices International

INDEX 3o-Sep-08 Monthly YTD INDEX 30-Sep-08 Monthly YTD
SENSEX 12,860.43 -11.7% -36.6% DJ INDU AVERAGE 10,850.66 -6.0% -18.2%
BSE-100 6,691.57 -12.2% -40.0% FTSE 100 EOD IDX 4,902.45 -13.0% -24.3%
BSE-200 1,555.70 -12.7% -41.4% XETRA DAX PF 5,831.02 -9.2% -27.7%
BSE-500 4,897.59 -13.0% -43.0% CAC 40 INDEX 4,032.10 -10.0% -28.2%
BSE MID-CAP 4,798.29 -16.4% -51.0% NIKKEI 225 INDEX 11,259.86 -13.9% -26.4%
BSE SMALL-CAP 5,577.47 -19.1% -58.2%
BSE-CG 10,581.13 -11.0% -46.4% BVSP BOVESPA IND 49,541.3 -11.0% -22.5%
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BSE-CD 2,929.18 -23.7% -57.9% SSE A SHARE IDX 2,408.9 -4.3% -56.4%
BSE-FMCG 2,160.76 -2.5% -6.9% SENSEX 12,860.4 -11.7% -36.6%
BSE-HC 3,672.18 -14.8% -16.9% RTS INDEX 1,211.84 -26.4% -47.1%
BSE-IT 3,095.08 -22.0% -31.7% YTD: From December 31, 2007 close
BSE-PSU 6,246.03 -7.4% -40.3% Nasdaq 2,426 (0.3)
BSE-TECK 2,545.91 -17.2% -36.6% Dow Jones 12,463 2.0
BSE BANKEX 6,478.85 -7.6% -43.3% Others
BSE AUTO 3,674.98 -8.2% -35.2% NAME Closing Monthly YTD
BSE METALS 8,992.06 -27.2% -55.1%
BSE OIL & GAS 9,039.28 -6.4% -32.0% GOLD 879.75 6.0% 5.6%
BSE REALTY 3,508.77 -29.8% -72.4% SILVER 12.14 -10.6% -17.8%
BSE POWER 2,260.27 -13.2% -50.3% NYMEX LIGHT CRUDE 101.56 -12.0% 5.8%
S&P CNX NIFTY 3,921.20 -10.1% -36.1% INR/USD 46.96 6.8% 19.1%
ALUMINIUM 2,391.00 -10.3% 1.4%
Institutional activity (Rs cr) COPPER 6,460.50 -14.5% -2.7%
Category Monthly YTD LEAD 1,806.50 -8.3% -29.0%
FIIs (8,665.1) (20,482.5) ZINC 1,664.50 -7.1% -29.3%
Mutual Funds 1,887.4 (4,265.0) NICKEL 16,165.00 -19.8% -37.9%
YTD: From December 31, 2007 492 (1,342)
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result, the currency has depreciated by 6.8% in the last Typically a EPC contract in power segment can be split
month. On the positive front, prices of crude oil and most into two - 1) BTG (boiler, turbine and generator) which
commodities have slipped, though they continue to see wild forms 60% of the EPC value and 2) BoP (balance of power)
swings, inflation on sequential basis is steady with the which forms the remaining 40% of the contract value. Both
possibility of it falling to single digit by middle of next year the two large projects which BGR has won include BTG
and chances that the tight monetary measures may be eased which will yield margins of 3-5%. The typical margins in
have increased. Equity valuations too have become attractive, BoP is 10-12%. The major competition is from larger players
although the risks of earnings downgrades remain high and like L&T, BHEL, Tata Projects and Reliance Infrastructure.
some may argue that we are still expensive when compared
to other markets. BGR has focussed on state generation companies and
electricity board where it has not seen slowdown. However,
Below we have given the trend in Sensex P/E multiple for the there is a slowdown in IPP sector. Considering its order backlog
last three years and estimates for the coming two years. Also we expect the company to register topline growth of 45%
we have given comparative multiples for the developed and for the coming two years. With the inclusion of BTG
emerging markets. (essentially trading) in topline the overall margins will come
down. The bottomline should grow upwards of 35%. The
BSE Sensex Estimates stock is attractively priced at current levels.
Y/E March 2006 2007 2008 2009F 2010F
Vakrangee (CMP: Rs139.20 ; PE1: 3.7x)
BSE Sensex 11,280 13,072 15,644 12,860 12,860 Vakrangee Sofware is one of the leading players in document
P/E (x) 21.6 19.2 18.4 12.9 10.6 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
Relative Valuations government organisations like land records in UP, electoral
INDEX PE1 PE2 Change (YTD) rolls for Election Commission, documents for 22 offices of
ROC (Registrar of Company). In FY08 it diversified its customer
DJ INDU AVERAGE 11.6 10.4 (18.2)
base by serving private companies in BFSI and telecom sectors.
FTSE 100 EOD IDX 8.3 7.9 (24.3) Last fiscal the split between Government & private, DMS &
XETRA DAX PF 10.8 9.2 (27.7) PMS and annuity & non-annuity was 63:37, 55:45 and 66:34
CAC 40 INDEX 8.9 8.2 (28.2) respectively. Vakrangee has no borrowings and has been
generating enough cash to take care of its expansion plans. It
NIKKEI 225 INDEX 14.0 13.0 (26.4)
has order book of Rs325cr to be executed in the current fiscal.
BVSP BOVESPA IND 8.5 7.0 (28.0) We estimate the company to grow its topline by 50% for the
SSE A SHARE IDX 13.8 11.3 (56.4) coming two years and maintain net profit margins between
BSE-500 11.7 10.2 (43.0) 18-20%. We find its stock attractively priced at current levels.
RTS INDEX 3.5 3.1 (47.1) Vakrangee - Business wise revenues
Y/E March 2006 2007 2008
Corporate Notes Government 100.0% 100.0% 62.9%
BGR Energy (CMP: Rs239.15 ; PE1: 12.3x) Private 0.0% 0.0% 37.1%
The two large orders 1) from TNEB for 600MW unit at Mettur Total 100.0% 100.0% 100.0%
valued at Rs3100cr and 2) for Kalisindh from RRVUNL for DMS 68.6% 75.9% 55.4%
2x600MW power plants valued at Rs4900cr have pulled up the PMS 31.4% 24.1% 44.6%
order backlog at Chennai based BGR Energy & Systems to
Total 100.0% 100.0% 100.0%
Rs11,000cr. The company is essentially into balance of plant
segment with in-house capabilities in design, civil and mechanical Annuity 38.5% 44.8% 65.6%
engineering services for power plants consisting of 20-25 Non-annuity 61.5% 55.2% 34.4%
packages like ash & coal handling, water treatment, cooling Total 100.0% 100.0% 100.0%
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 2
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Engineers India Company Report

Curent Price Rs560.00 Summary

Indices Established in 1965 to provide engineering and technical services for petroleum
Sensex 12860.43 refineries and petrochemicals industry, Engineers India (EIL) has extended its services
Nifty 3921.20 to the following sectors - petroleum, gas pipelines, offshore structures & platforms,
non-ferrous metal industry and infrastructure. There has been increased activities
BSE Code 532178 in the oil & gas space in the recent past and the momentum is likely to be maintained
NSE Code ENGINERSIN going forward. The future oil & gas needs call for an investment of $10trillion by
Bloomberg ENGR IN the year 2030 according to International Energy Agency. Domestically addition of
Reuters ENGI.BO 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
Stock Data
Rs5000cr. We expect the company to show growth upwards of 25% for the coming
Share O/S 56.16mn 2 years both in revenues and net profits. EIL is debt free, making good margins
Market Cap Rs32.29bn and return on capital, consistently generating free cash flows for the last few years
52 Wk H/L (Rs) 1284/425 and has cash & equivalents of Rs223 per share. Valuations are very attractive.
Av. Daily Vol 5,000
Good order intake and backlog:
Free Float (%) 9.6%
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
Shareholding Pattern 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
Public &
quality upgradation project under implementation. In the overseas market an overall
Others volume of new business of Rs264cr was secured mainly from UAE and Algeria.
3% The total order book at the end of year is Rs5000cr approximately which has
Promoters doubled over the previous year.
FIIs
91%
1%
Diversification:
MF
5% 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 Y/E March (Rs cr) 2007 2008 2009 F 2010 F
Revenues 571.1 737.8 1,068.4 1,442.3
250
Growth -27.8% 29.2% 44.8% 35.0%
200 PAT1 143.0 194.6 273.6 372.1
150 Growth 3.1% 36.1% 40.6% 36.0%
EPS (Rs) 25.5 34.7 48.7 66.2
100
P/E (x) 17.8 19.2 11.8 8.7
50 P/B (x) 5.1 6.1 6.8 7.3
Oct-07

Feb-08

Jun-08
Dec-07

Apr-08

Aug-08

P/S (x) 4.5 5.1 3.0 2.2

EV/EBITDA (x) 13.2 13.9 6.2 3.4
Engineers India BSE-Sensex OPM 19.4% 22.9% 23.0% 23.0%
Tax rate -28.8% -32.9% -32.6% -32.6%
NPM 25.0% 26.4% 25.6% 25.8%
Receivables 136 93 74 76
Inventories 12 15 17 18
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
Source: Company & Religare PMS

October 2008 3
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diverifying into offering services to non-ferrous metals Risks factor:

industry, it has extended its services to infrastructure sector
Slow down or delay in the investment demand for the
which covers urban water management, airport
company’s services.
modernisation, sports facilities etc. Currently it has order book
of Rs150cr in metals and Rs160cr in infrastructure space. Most of the customers are PSU oil refining and marketing
These include alumina refinery project of JSW Alumina, companies which have cash flow constraints due to under-
expansion projects of NALCO, Yamuna Action Plan, sport recoveries and subsidies.
venues for Commonwealth Games 2010, strategic crude oil
Attraction and retention of skilled engineers within the
storages at 3 locations etc.
company.
Focus on Technology: Low floating stock and lack of liquidity has resulted into
EIL continues to lay emphasis on the role of R&D in the lower valuations.
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: Quarterly Income Statement
World’s energy requirements are growing rapidly. According Quarter to end (Rscr) 2007 2007 2008 2008
09 12 03 06
to The World Economic Outlook 2007 predictions world
Revenues 166.99 177.45 242.82 252.44
energy needs would grow by 55% from 11.4bn TOE (Tonnes
Growth 28.0% 35.3% 49.2% 67.7%
of Oil and Oil Equivalents) to 17.7bn TOE during 2005-2030.
India and China alone are expected to account for 45% of Expenditure -120.09 -128.79 -197.63 -209.21
this increase. This calls for an investment of USD10trillion by Employee Expenses -78.72 -78.13 -87.7 -93.8
the year 2030 according to International Energy Agency. Other Expenses -41.37 -50.66 -109.93 -115.41

Almost all refiners in the country are investing more in capacity Operating Profits 46.9 48.66 45.19 43.23
expansion and fuel up-gradation projects. Addition of 91mn Growth 44.1% 37.3% 224.4% 54.3%
TPA in refining capacity during XI Plan and over 2.0mn TPA Depreciation -3.7 -2.23 -2.76 -2.04
Ethylene Cracker in petrochemicals sector is on the anvil. Interest 0 0 -0.03 0
To participate increasingly in EPC/LSTK projects in oil & gas Other Income 29.93 28.82 44.95 34.35
and infrastructure sectors both in India and overseas EIL has PBT 73.13 75.25 87.35 75.54
pursued setting up joint ventures 1) with Tata Projects called Tax - Current -28.58 -22.18 -25.79 -30.19
TEIL Projects for undertaking EPC projects for hydrocarbon,
Tax - Deferred 5.7 -2.16 -4.13 5.94
power and other sectors and 2) with Tecnimont SPA, Italy
Tax - FBT -0.65 -0.66 -0.75 -0.66
for executing EPC projects in UAE. While TEIL has already
been incorporated, the latter venture has been approved by PAT1 49.6 50.25 56.68 50.63
GOI and the process of incorporation has been set in motion. Growth 51.4% 26.0% 33.3% 33.0%

Based on the order backlog of Rs5000cr and ongoing Non-recurring 0.04 0.05 19.86 0
execution EIL will cross FY07 revenues of Rs571cr by the PAT2 49.64 50.3 76.54 50.63
middle of this fiscal itself. Growth 46.9% 22.9% 28.6% 32.9%

EIL bagged Rs3202cr of orders last fiscal taking its order

backlog to Rs5000cr. We expect the company to show growth Equity shares o/s cr 5.62 5.62 5.62 5.62
upwards of 25% for the coming 2 years both in revenues EPS (Rs) 8.8 8.9 10.1 9.0
and net profits. EIL is debt free, making good margins and OPM 28.1% 27.4% 18.6% 17.1%
return on capital, consistently generating free cash flows for P/E 20.0 29.8 19.2 13.7
the last few years and has cash & equivalents of Rs223 per
CLOSE" 606.05 956.85 666.60 504.15
share. Valuations are very attractive.

October 2008 4
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Income statement Balance Sheet

Y/E March (Rscr) 2007 2008 2009 F 2010 F Y/E March (Rscr) 2007 2008 2009 F 2010 F
Revenues 571.1 737.8 1,068.4 1,442.3 Current assets of which 1,437.5 1,823.1 2,389.6 3,050.5
Growth -27.8% 29.2% 44.8% 35.0% Cash & bank balance 941.4 1,252.6 1,563.4 1,935.1
Expenditure (460.1) (569.0) (823.1) (1,111.2) Receivables 200.2 176.6 255.7 345.2
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
Operating Profits 111.0 168.8 245.3 331.1 Investments 137.4 146.8 156.8 166.8
Growth -22.6% 52.0% 45.3% 35.0% Gross Block 144.7 158.1 163.1 168.1
Depreciation (8.3) (10.3) (11.9) (12.0) Acc Depreciation (106.4) (111.2) (123.1) (135.2)
Interest (0.1) (0.0) (0.0) (0.1) CWIP 1.4 3.5 5.0 5.0
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) Miscellaneous Exp 0.7 0.4 - -
Tax - Deferred 27.6 4.6 5.1 7.2 Total assets 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 Current liabilities of which 666.2 964.5 1,396.8 1,885.7
Growth 3.1% 36.1% 40.6% 36.0% CL 520.8 797.3 1,154.7 1,558.8
Non-recurring 20.0 20.0 - - Provisions 145.4 167.2 242.1 326.9
PAT2 163.0 214.6 273.6 372.1 Borrowings - - - -
Growth 9.4% 31.6% 27.5% 36.0% Shareholders' funds 1,031.5 1,152.1 1,294.6 1,489.6
Dividends (53.4) (61.8) (67.4) (73.0) Equity 56.2 56.2 56.2 56.2
DivTax (8.5) (10.3) (11.2) (12.2) Reserves & Surplus 975.4 1,095.9 1,238.4 1,433.4
DPS 9.50 11.00 12.00 13.00 Total liabilities & Equity 1,697.7 2,116.6 2,691.4 3,375.3

Ratios Free Cash Flow To Firm

Y/E March 2007 2008 2009F 2010F Y/E March (Rs cr) 2007 2008 2009 F 2010 F
EPS (Rs) 25.5 34.7 48.7 66.2 EBIT 102.7 158.4 233.4 319.1
DPS (Rs) 9.5 11.0 12.0 13.0 EBIT margins 18.0% 21.5% 21.8% 22.1%
BV (Rs) 183.7 205.1 230.5 265.2 Effective tax rate -30.1% -33.8% -33.5% -33.5%
Valuations EBIT * (1-tax rate) 71.8 104.9 155.2 212.2
P/E (x) 17.8 19.2 11.8 8.7 NCC 35.9 14.9 17.0 19.2
P/B (x) 5.1 6.1 6.8 7.3 WCInv (239.0) 42.6 143.1 154.3
P/S (x) 4.5 5.1 3.0 2.2 (Inc)/Dec in receivables 23.7 (79.1) (89.5) (103.5)
EV/EBITDA (x) 13.2 13.9 6.2 3.4 (Inc)/Dec in inventories (15.9) (14.3) (16.2) (18.7)
Operating/Returns (Inc)/Dec in loans & adv. (82.2) (162.3) (183.5) (212.3)
OPM 19.4% 22.9% 23.0% 23.0% Inc/(Dec) in payables (164.7) 298.3 432.3 488.9
Tax rate -28.8% -32.9% -32.6% -32.6% FCInv (7.2) (15.5) (6.5) (5.0)
NPM 25.0% 26.4% 25.6% 25.8% FCFF (138.6) 147.0 308.8 380.7
Receivables (Days) 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

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Investment wisdom
Current Problems in Security Analysis Lecture $25 a share represented the investment component and as
No.10 by Benjamin Graham... much as $13 a share represented the speculative
component. Hence in this very high-grade issue about one-
In this issue of Investment Wisdom we have covered one of third of the average price in a more or less average market
the lectures given by Mr. Benjamin Graham on the series represents a speculative appraisal. That example, which
entitled Current Problems in Security Analysis presented at showed how considerable was the speculative component
the New York Institute of Finance from September 1946 to in investment securities is pretty typical of security value
Februrary 1947. The last lecture sheds light on speculation developments since World War I. It justifies and explains
in relation to security analysis and tries to bring out some the first point that speculative elements have become more
less obvious aspects of this important element in finance. and more important in the work of an analyst. “I think only
The two main points he made were 1) speculative elements people who have been in Wall Street for a great many
are of some importance in nearly all the work of the security years can appreciate the change in the status of investment
analyst, and that the over-all weight and significance of in common stocks that took place in the last generation,
speculation has been growing over the past thirty years. 2) and the extent to which speculative considerations have
there is a real difference between intelligent and unintelligent obtruded themselves in all common stocks. When I came
speculation, and that the methods of security analysis may down to the Street in 1914, an investment issue was not
often be of value in distinguishing between the two kinds regarded as speculative, and it wasn’t speculative.” Its price
of speculation. was based primarily upon an established dividend. It
So to begin with what do we mean by speculation? There fluctuated relatively little in ordinary years. And even in
is a chapter in Graham’s book Security Analysis which is years of considerable market and business changes the price
devoted to the distinctions between investment and of investment issues did not go through very wide
speculation. “An investment operation is one which, on fluctuations. It was quite possible for the investor, if he
thorough analysis, promises safety of principal and a wished, to disregard price changes completely, considering
satisfactory return. Operations not meeting these only the soundness and dependability of his dividend return,
requirements are speculative.” and let it go at that -- perhaps every now and then subjecting
his issue to a prudent scrutiny.
Speculative operations are all concerned with changes in
price. In some cases the emphasis is on price changes alone, The problem is not whether price changes should be
and in other cases the emphasis is on changes in value disregarded but rather in what way can the investor and
which are expected to give rise to changes in price. This is the security analyst deal intelligently with the price changes
a rather important classification of speculative operations. which take place. In the case of General Electric a
It is easy to give examples. considerable portion of the price in 1939 reflected a
speculative component. That arises from the fact that
If at the beginning of 1946 a person bought U.S. Steel at
investors have been willing to pay so much for so-called
around 80, chiefly because he believed that in the latter
quality, and so much for so-called future prospects, on the
part of bull markets the steel stocks tend to have a
average, that they have themselves introduced serious
substantial move, that would clearly be a speculative
speculative elements into common stock valuations. These
operation grounded primarily on an opinion as to price
elements are bound to create fluctuations in their own
changes, and without any particular reference to value. On
attitude, because quality and prospects are psychological
the other hand, a person who bought Standard Gas and
factors. The dividend, of course, is not a psychological factor;
Electric, $4 preferred, sometime in 1945, at a low price, --
it is more or less of a fixed datum. Matters of prospects and
say at four dollars a share -- because he thought the plan
quality are subject to wide changes in the psychological
which provided for its extinction was likely to be changed,
attitude of the people who buy and sell stocks. Thus we
was speculating undoubtedly. But there his motive was
find that General Electric will vary over a price range almost
related to an analysis of value -- or rather to an expected
as wide as that of any secondary stock belonging in more
change of value -- which, as it happened, was realized
or less the same price class. A very considerable part of the
spectacularly.
price of General Electric must be regarded as speculative
The chapter on speculation and investment covers discussion and perhaps temporary.
on the concept of the speculative component in a price. A
On the second point, which relates to the analyst’s role in
security might sell at a price which reflected in part its
distinguishing intelligent from unintelligent speculation,
investment value and in part an element which should be
Graham picked out four low-price securities, which would
called speculative. The example the authors gave back in
illustrate the different kinds of results which an analyst may
1939-1940, with considerable trepidation, was that of
get from dealing with primarily speculative securities. These
General Electric. They intentionally picked out the highest-
are, on the one hand, Allegheny Corp. Common, which
grade investment issue to illustrate the element of
sold at the end of the month at five, and Graham-Paige
speculation existing in it. Of the price of $38, which it
Common, which sold at five; and, on the other hand,
averaged in 1939, the analyst might conclude that about

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General Shareholdings, which sold at four, and Electric Bond represents about $8-million of asset value, most of which is
and Share six dollars Preferred “Stubs”, which could be in Kaiser-Fraser stock. This you can buy if you want in the
bought at the equivalent of three. When we first look at open market, instead of having to pay three times as much
these securities, they all seem pretty much the same -- for it. The rest of the price represents an interest in $3-
namely, four speculative issues. But a deeper examination million of assets in the farm equipment business -- which
by a security analyst would reveal a quite different picture may prove profitable, as any business may be profitable.
in the two pairs of cases. In the case of General Shareholdings The only weakness to that is that there is no record of
we have the following: This is the common stock of an profitable operations here, and you are paying a great many
investment company, which has $21.5-million of total assets, millions of dollars merely for some possibilities. That, in turn,
with senior claims of $12-million, and a balance of about would be regarded as an unintelligent speculation by the
$9.5-million for the common. The common is selling for security analyst. Let us move on now to the Electric Bond
$6,400,000 in the market. That means that in General and Share Stubs. They represent what you would have left
Shareholdings you have both a market discount from the if you had bought Electric Bond and Share Preferred at $73
apparent present value of the stock and an opportunity to yesterday and had then received $70 a share that is now to
participate in a highly leveraged situation. For if you pay be distributed. What remains is an interest in a possible $10
$6.4-million of the gross asset value; and consequently every payment, your claim to which is to be adjudicated by the
ten per cent of increase in total asset value would mean a SEC and the courts. That $10 represents the premium above
30 per cent increase in the book value of the common. par to which Electric Bond and Share Preferred would be
Furthermore, you are practically immune from any danger entitled if it were called for redemption. The question to be
of serious corporate trouble; because the greater portion of decided is whether the call price, the par value, or some
the senior securities -- in fact, five-sixths of it -- is represented figure in between should govern in this case. It should be
by a preferred stock on which dividends do not have to be obvious that that is a speculative situation. You may get $10
paid and on which there is no maturity date. Consequently, a share out of it for your $3, and you may get nothing at all,
in the General Shareholdings case, you have that typically or you may get something in between. But it is not a
attractive speculative combination of (a) a low-price “ticket speculative operation that eludes the techniques of the security
of entry” into a fairly large situation; and (b) instead of analyst. He has means of examining into the merits of the
paying more than the mathematical value of your ticket, case and forming an opinion based upon his skill, his
you are paying less; and (c) if you assume that wide experience, and the analogies which he can find in other
fluctuations are likely to occur in both directions over the public utility dissolutions. If we were to assume that the Electric
years, you stand to gain more than you can lose from these Bond and Share Stubs have a 50-50 chance of getting the
fluctuations. By contrast, if you go to Allegheny Corporation $10 premium, then he would conclude that at $3 a share
at five, although it seems at first to be a somewhat similar they are an intelligent speculation. For the mathematics
situation -- namely an interest in an investment company indicates that, in several such operations, you would make
portfolio -- you find the mathematical picture completely more than you would lose in the aggregate. These examples
different. At the end of 1945 the company had about $85- lead us, therefore, to a mathematical or statistical formulation
million of assets, and against it there were $125-million of the relationship between intelligent speculation investment.
claims in the form of bonds and preferred stocks, including The two, actually, are rather closely allied.
unpaid dividends. Thus the common stock was about $40- Intelligent speculation presupposes at least that the
million “under water.” Yet at five you would be paying mathematical possibilities are not against the speculation,
$22-million for your right to participate in any improved value basing the measurement of these odds on experience and
for the $85-million of assets, -- after the prior claims were the careful weighing of relevant facts. This would apply for
satisfied. The security analyst would say that there is plenty example, to the purchase of common stocks at anywhere
of leverage in that situation, of course; but you are paying within the range of value that we find by our appraisal
so much for it, and you are so far removed from an actual method. Earlier it was concluded that American Radiator
realizable profit, that it would be an unintelligent speculation. was apparently worth between $15 and $18 a share. If we
The fact of the matter is you would need a 70% increase in assume that that job was well done, we could draw these
the value of the Allegheny portfolio merely to be even with conclusions. The investment value of American Radiator is
the market price of the common as far as asset value about $15; between 15 and 18 you would be embarking
coverage is concerned. In the case of General Shareholdings, on what might be called an intelligent speculation, because
if you had a 70% increase in the value of its portfolio, you it would be justified by your appraisal of the speculative
would have an asset value of about $15 a share for the factors in the case. If you went beyond the top range of
common, as against a market price of around $4. Thus, $18 you would be going over into the field of unintelligent
from the analytical standpoint, while Allegheny and General speculation. If the probabilities, as measure by our
Shareholdings represent approximately the same general mathematical test, are definitely in favor of the speculation,
picture, there is a very wide quantitative disparity between then we can transform these separate intelligent
the two. One turns out to be an intelligent and the other an speculations into investment by the simple device of
unintelligent speculation. Passing now to Graham-Paige at diversification. For real diversification; you must be sure that
$5, we find another type of situation. Here the public is the factors that make for success or failure differ in one
paying about $24-million for a common stock which case from another...

October 2008 7
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