One of my favorite Benjamin Graham investments to review is his early career investment in the Northern Pipeline. In 1911, the Supreme Court ordered that the Standard Oil Trust be broken into over fifty separate entities, and he began to study the various pipelines that were being split up into eight entities.
Since the pipelines amounted to less than one-seventh of the overall Standard Oil empire, and since the Northern Pipeline was just one of the eight pipeline entities becoming its own after the breakup, the Standard Oil income statements do not classify Northern Pipeline according to anything that would resemble a balance sheet overview–investors were only given access to the net income and other similar figures.
When Graham himself began to study the pipelines, he personally traveled to Washington, D.C. in order to pick up copies of each of the pipeline’s filings with the Interstate Commerce Commission. He saw that Rockefeller was installing very conservative management at the Northern Pipeline, and that unlike the other pipelines which would be carrying balance sheet liabilities, the Northern Pipeline stock was going to be divided into its own publicly traded company with 3.8 million shares outstanding and $360 million in railroad bond investment.
When it began publicly traded it was at $65 per share. Not only was it earning $8.20 per share in profits, for a P/E ratio of only 8x earnings, but each share was sitting on $95 per share in bonds.
Graham, having formed an investment partnership with Jerry Newman, purchased 170,000 shares of Northern Pipeline. He started bragging to potential clients about the drastically undervalued stock he found, and as he gobbled up shares, confidently told his investors that a big $90 dividend would come as soon as he wrote a letter to management requesting that they do so. Given that Graham was in his 20s, the exuberant naivete should be excused.
In any event, after making his third request for a $90 distribution, the Northern Pipeline Board sent a letter to Mr. Graham that stated, in part:
““Look, Mr. Graham, we have been very patient with you and given you more of our time than we could spare. Running a pipeline is a complex and specialized business, about which you can know very little, but which we have done for a lifetime. You must give us credit for knowing better than you what is best for the company and its stockholders. If you don’t approve of our policies, may we suggest that you do what sound investors do under such circumstances, and sell your shares?”
When he received this letter, the price of the stock had fallen to $50, from Graham’s initial purchase price of $65. The partnership, which had put a sizable chunk of the client’s assets into this investment, saw the $11 million investment fall to $8.5 million in value.
This is where the point where the reputational capital of Jerry Newman bailed Graham out. A lot of wealthy investors don’t like when an articulate sounding-kid turns $11 million into $8.5 million in a few months’ time. The large investors were questioning Graham’s judgment, and placing calls to Jerry Newman questioning whether he had delegated too much power to the young protege that could make his case convincingly but perhaps lacked the mettle to succeed on Wall Street.
When Graham fielded such calls, he would cite to the $360 million in railroad bonds on the balance sheet that exceeded the value of the Northern Pipeline stock that had fallen in value $190 million in market cap. The investors, aware of the Northern Pipeline letter and $15 price decline, dismissed his comments and went straight to Jerry Newman to voice their complaints.
What did Newman say? The same thing. He pointed out that investments take some time there, and value investing must tolerate an uncertain “when” in order to receive renumeration for the certain “what.” He, too, cited favorably to these railroad bonds.
The investors held on, and Graham voted himself onto the board and began contacting other large investors to demand a distribution. A year and a half later, the Board finally agreed and made a $70 distribution, followed by three subsequent distributions that totaled $110 over the subsequent two years. Basically, Graham and Newman collected $18 million in special dividends for their investors, on an $11 million investment within three years.
This is separate from the regular $6.25 per share dividend that Northern Pipeline paid, which added over $3 million more to the dividend count. Plus, the original investment shot up to $150 per share, putting the value of the shares at $25 million. Northern Pipeline was the investment that put Graham on the map.
It established Graham’s reputation and put him on the path to becoming “the father of value investing”, as he is known today. But yet, it was Jerry Newman’s reputation, and the way he wielded it, during the moment when Northern Pipeline stock fell from $65 to $50 and cost the investors in the Graham-Newman Partnership $3 million quickly that enabled this success. If Graham were a sole operator, or if Newman was not willing to let Graham lean on his reputation, this investment would not have reached its favorable outcome and who knows what would have come of Graham without the early-career credibility and fees collected from this investment.
That is an important part of success, which I’ll define as “realizing what you set out to accomplish”, that is often neglected analytically. Not only do you need to identify the correct meaningful task, and have your own perseverance to see it through, but you must also recognize the externalities that bear upon you and realize how they must be negotiated.
In investing, the age-old credibility issue is getting investors to stick with an investment that is plummeting in price that the manager believes is worth not only significantly more than the fallen price, but significantly more than whatever price he paid for the security. It is not job about knowing the arguments that can explain the value, but having the ability to actually persuade those who need to be persuaded to their point. The best way to be in this position is to have a history of prior successes that establish credibility so that the analytical arguments are taken seriously by the source.
The credibility aspect of persuasiveness is often ignored by rationalists, as they know that this is essentially “appeal to authority” in drag and think that a logical fallacy should be disregarded in entirely. This results in such individuals making the logical error of thinking that logical fallacies are not a factor in determining one’s life outcomes. Benjamin Graham became a success, in part, because he did not get wiped out and lose credibility from losing $3 million on Northern Pipeline stock during an early price decline. It was the prior success of Jerry Newman that vouched for him and enabled him to ultimately prevail.
As the New Year approaches and people think about resolutions, I would think many would do well to not only focus on the “B” part of the A to B they want to move towards, but also, realizing the condition precedents that are required survive the likely low points on the journey from A to B should be a goal unto itself as well.