Dear Chairman

Jeff Gramm

• Publisher: Harper Business
• Year: 2016
• ISBN:
  9780062369840
• Topic: Commerce
• Subtopic: Leadership

A sharp and illuminating history of one of capitalism's longest running tensions—the conflicts of interest among public company directors, managers, and shareholders—told through entertaining case studies and original letters from some of our most legendary and controversial investors and activists.

Recent disputes between shareholders and major corporations, including Apple and DuPont, have made headlines. But the struggle between management and those who own stock has been going on for nearly a century. Mixing never-before-published and rare, original letters from Wall Street icons—including Benjamin Graham, Warren Buffett, Ross Perot, Carl Icahn, and Daniel Loeb—with masterful scholarship and professional insight, Dear Chairman traces the rise in shareholder activism from the 1920s to today, and provides an invaluable and unprecedented perspective on what it means to be a public company, including how they work and who is really in control.

Jeff Gramm analyzes different eras and pivotal boardroom battles from the last century to understand the factors that have caused shareholders and management to collide. Throughout, he uses the letters to show how investors interact with directors and managers, how they think about their target companies, and how they plan to profit. Each is a fascinating example of capitalism at work told through the voices of its most colorful, influential participants.

A hedge fund manager and an adjunct professor at Columbia Business School, Gramm has spent as much time evaluating CEOs and directors as he has trying to understand and value businesses. He has seen public companies that are poorly run, and some that willfully disenfranchise their shareholders. While he pays tribute to the ingenuity of public company investors, Gramm also exposes examples of shareholder activism at its very worst, when hedge funds engineer stealthy land-grabs at the expense of a company's long term prospects. Ultimately, he provides a thorough, much-needed understanding of the public company/shareholder relationship for investors, managers, and everyone concerned with the future of capitalism.

1

Benjamin Graham versus Northern Pipeline: The Birth of Modern Shareholder Activism

“The cash capital not needed by these pipe line companies in the normal conduct of their business, or to provide for reasonable contingencies, should be returned to the stockholders, whose property it is, in the form of special dividends and/or reductions of capital.”

—BENJAMIN GRAHAM, 1927

HERE WAS I, A stout Cortez-Balboa, discovering a new Pacific with my eagle eye.”¹ The year was 1926, and Benjamin Graham was sitting in the Interstate Commerce Commission (ICC) reading room in Washington, D.C., studying Northern Pipeline Company’s balance sheet. Nobody on Wall Street—not even the brokerage houses that had followed Northern Pipeline for years—had bothered to look up the company’s public ICC report. As the stock languished at $65, the report revealed that Northern Pipeline generated over $6 per share in annual earnings and owned millions of dollars of investment securities worth $90 per share. Benjamin Graham described the feeling years later in his memoir: “I had treasure in my hands.”² All he had to do now was convince Northern Pipeline’s management to share the company’s wealth with its stockholders.

At a time when the stock market was little more than a betting pool, Benjamin Graham developed a value investing style based on rigorous analysis of company fundamentals. By focusing on companies’ intrinsic values, Graham and his followers were hugely successful at capitalizing on market inefficiencies created by the more speculative investing public. The gradual acceptance of Graham’s lessons has led to more efficient markets that trade closer to fair value than they did in his time. But one arbitrage persists to this day. It is caused by the frequent divergence of interests between management and shareholders.

When Benjamin Graham confronted Northern Pipeline’s management in 1926, he took a path untrodden. Shareholder interventions at that time usually involved lingering disputes between large minority owners or strategic buyers seeking control. A recent academic study charting shareholder activism from 1900 through 1949 found only seven instances where a financial buyer running an investment vehicle led an offensive activist campaign.³ And many of those early contests were quite tame. When brokerage firm J. S. Bache sought board representation at Central Leather in 1911, it merely wanted the company to provide quarterly financial updates to shareholders.⁴

Why was shareholder activism so rare in the early twentieth century? First of all, ownership at public companies was concentrated into very few hands—usually founders, family owners, or entrepreneurial financiers. This made it hard for outside shareholders to have any influence.⁵ Second, public companies shared very little financial information with shareholders. This limited investors’ ability to value companies objectively. Graham saw both of these forces at play at Northern Pipeline. None of the other shareholders knew the company was hoarding so much capital, and the Rockefeller Foundation effectively controlled Northern Pipeline’s management through a 23% equity stake.

Beyond these structural constraints there was a subtle societal one: Wall Street was an elite insiders’ club that viewed pushy stockholders as extortionists. But all of this was changing. Benjamin Graham himself led a revolution in fundamental analysis that received a tailwind from disclosure requirements in the Securities and Exchange Act of 1934. Ownership in public companies was rapidly diffusing in a way that would drastically alter the nature of corporate oversight. As for etiquette? When real money is at stake, etiquette goes out the window. The large railroads were the first public companies to share detailed financial information with a widespread stockholder base. Before the turn of the twentieth century, many of them were subject to vicious, backstabbing fights for control, such as the Erie Railway proxy battle, and Cornelius Vanderbilt’s takeover of the New York Central.⁶

Benjamin Graham is often regarded as a distant intellectual forebear of today’s hedge fund managers and shareholder activists. But this view gives him much less credit than he deserves. Graham was a hedge fund pioneer, founding a partnership that shorted securities and collected performance-based fees more than a decade before the launch of A. W. Jones, which is often called the world’s first hedge fund.⁷ Graham was also one of the first professional investors to regularly employ shareholder activism as part of his investing strategy. Northern Pipeline was his first attempt at actively engaging a company’s management. Little did he know how hard it would be to wrest treasure from the hands of Northern Pipeline’s executives. Graham’s campaign is a classic example of an investor challenging an overcapitalized company to return cash to shareholders, and one of the earliest examples of modern shareholder activism.

A REVOLUTIONARY IDEA

Not long ago I drove to the village of Sleepy Hollow, New York, in search of the letter Benjamin Graham wrote to the Rockefeller Foundation about Northern Pipeline. My trip started in Brooklyn, where more than one hundred years earlier Graham was a star pupil at Boys High School in Bedford-Stuyvesant. The Brooklyn–Battery Tunnel scooted me past Wall Street, where he began his career in 1914 and became, in his words, “something of a smart cookie in my particular field.”⁸ I took the Henry Hudson Parkway past Columbia University, where students can take securities analysis, based on a textbook written by Graham that remains in print eighty years after it was first published. Then I entered Westchester County, where Graham’s student Warren Buffett moved his young family from Omaha, Nebraska, for the opportunity to work at Graham-Newman in 1954. Just off the Saw Mill River Parkway, about ten miles from the Rockefeller estate, I passed Westchester Hills Cemetery, where Benjamin Graham’s ashes were buried in 1976.

Almost forty years after his death, Benjamin Graham remains a towering figure in the investment world. While his investment partnership made him famous—Graham-Newman beat the market significantly over its twenty-one years of operation—Graham’s writings about investing and the tremendous success of his former students are his legacy.⁹ We’re all familiar with Warren Buffett, but let’s not forget Walter Schloss, a former Graham-Newman analyst who started his own fund in 1955. Through 2000, Schloss’s fund compounded at 15.7% annually versus the S&P 500’s 11.2% annual gain. If you had invested in Schloss’s fund in 1955, you would have made more than 700 times your money, versus about 120 times if you had stuck with the S&P 500.¹⁰ In addition to Buffett and Schloss, Graham taught value investors Bill Ruane and Irving Kahn, whose funds also beat the market handily over long periods.

Benjamin Graham’s books have achieved cultlike status among investors and continue to sell today. Security Analysis (written with David Dodd) is a dense seven-hundred-page textbook with outdated accounting discussions and mind-numbing railroad bond analyses. But for some value investors, choosing between the 1934, 1940, 1951, and 1962 editions of Security Analysis is an act of self-expression in the same way music geeks identify with their favorite Velvet Underground record. I’m partial to Graham’s 1949 book for the layperson, The Intelligent Investor, which captivated nineteen-year-old Warren Buffett in 1950 and forever changed the course of his life.

Whereas Security Analysis focuses on valuing bonds and stocks, and their underlying operating businesses, The Intelligent Investor teaches us something just as important—how to think about markets. These are Graham’s most enduring lessons because, more than anything else, volatile markets are the downfall of aspiring investors. It’s easy to learn how to value companies, but you’re in trouble if you don’t understand markets and risk.

The Intelligent Investor is most famous for the parable of Mr. Market and the concept of “margin of safety.” After Graham describes how market fluctuations put damaging financial and psychological pressure on investors, he introduces Mr. Market, the personification of frenetic stock price movements. Imagine you have paid $1,000 to own a share of a private company. One of your partners, Mr. Market, lets you know every day what he thinks your share is worth. Sometimes he puts a sensible value on your share, but often he gets carried away by greed or fear and offers you a price that is far too high or far too low. Two things are certain: He is always willing to buy your stake or to sell you his at the price he quotes, and he never gets offended if you say, “No thanks!” Mr. Market will be ready with a new quote the next day.

An obliging source of liquidity, Mr. Market should be a valuable business partner. You can sell to him when his price is too high, and buy from him when the price is too low. There’s no reason that Mr. Market’s prices should influence your own view of what your share is worth. Yet in the real world, investors often buy and sell at the wrong times, because the market’s fluctuations affect their judgment. In rising markets, we are easily seduced into speculative buying. In falling markets, we risk losing our conviction to the prevailing pessimism of the moment.¹¹ Graham wrote, “[P]rice fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”¹²

Benjamin Graham concludes The Intelligent Investor by discussing margin of safety as “the central concept of investment.” In some ways, Graham had a fairly rigid idea of what margin of safety meant. For railroad bonds, for instance, Graham wanted the company’s pretax income to cover its fixed charges five times over. But he also offered a more fundamental description. In the case of an undervalued stock, Graham believed a wide difference between its price and its “appraised value” provided a margin of safety against declining earnings.¹³ This notion of a stock having an “intrinsic value” might seem trivial today, but in Benjamin Graham’s time it was a revolutionary idea.

WHEN GRAHAM ARRIVED on Wall Street in 1914, markets for corporate bonds and preferred stocks dwarfed trading in common stocks. The total value of outstanding railroad bond issues, for example, exceeded that of railroad common stocks by more than 50%.¹⁴ Railroad stocks, for their part, accounted for over 40% of all publicly issued equity securities.¹⁵ While it would be twenty years until the Securities Exchange Act required companies to file regular financial reports, the Interstate Commerce Commission and various state regulators collected a tremendous amount of information about railroad companies. Cross-holdings were very common, so railroads often owned shares of other railroads. An investor who could find a bargain railroad stock could profit on the issuer as well as other railroads with large holdings of the stock.

With so much publicly available operating data on railroad companies, and such large profits available to anyone who could identify the winners, you would expect Wall Street’s finest to diligently pore over ICC reports. Instead, as Graham wrote in his memoirs, “this mass of financial information was largely going to waste in the area of common-stock analysis.”¹⁶ What really drove markets were rumors and inside information. A company’s stock might shoot up on speculation about an anticipated large customer order. More often, market participants fixated on the intentions of large speculators that could drive a stock up or down with aggressive buying or selling. As Graham explained, “To old Wall Street hands it seemed silly to pore over dry statistics when the determiners of price change were thought to be an entirely different set of factors—all of them very human.”¹⁷

Graham was a clear and rigorous thinker who approached each company by ignoring market rumors and focusing instead on its historical financial data. He would step away from the Wall Street noise to ponder, What do I really know about this company? He worked from there to determine if it had intrinsic value from future earnings or the liquidation value of its assets. Once he had a better understanding of a company’s intrinsic value, he valued the shares as fractional ownership interests. Graham later wrote, “I found Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.”¹⁸

Benjamin Graham’s nickname, “the Dean of Wall Street,” is fitting, given his tutelage of so many future titans of the industry. But it’s also a nod to his scholarly manner. Graham’s memoirs feature more passages from Roman poets than quotations of the stock market variety. And before he decided to pursue a career in business, he weighed separate offers for teaching posts at Columbia University’s departments of philosophy, mathematics, and English. Benjamin Graham was a thoughtful outsider in the investment community, and he used it to his advantage. He was the perfect man to sift through Wall Street’s bullshit in search of intrinsic value.¹⁹

Graham knew that undervalued common stocks could provide a margin of safety while promising greater upside than most bond investments. As with his fixation on hard data and intrinsic value, this view was ahead of its time. In 1914, most investors focused on bonds and dismissed common stocks as purely speculative. Even when Graham retired in the mid-1950s, the stock market was commonly regarded as a wasteland for scams and speculators. And who’s to say it wasn’t? While most sophisticated investors stuck to bonds, stocks were left to speculators, manipulators, and, of course, Graham and his pupils, who were making a quiet killing. But bond investors were not just overlooking available profits by ignoring stocks. Common stocks allow their holders to vote on the composition of the company’s board of directors. This gives large shareholders the opportunity to intervene in the governance of the company. The stock market was the market for corporate control.

AN UNSUSPECTING TARGET

Northern Pipeline was one of eight pipeline companies created in 1911 when the U.S. Supreme Court broke apart John D. Rockefeller Sr.’s Standard Oil monopoly. In 1926, Graham was looking up some railroad data in the Interstate Commerce Commission’s annual report when he saw a table of pipeline statistics. Under the table were the words, “taken from their annual report to the Commission.”²⁰ Graham hadn’t known that pipeline companies submitted financial information to the ICC, and he assumed none of his peers on Wall Street knew, either. He quickly boarded a train for Washington, D.C.

It turned out that each of the pipeline companies filed a twenty-page annual report to the ICC with very detailed financial statements. The report also contained schedules of employee salaries, capital expenditures, the names and addresses of shareholders, and, of particular interes...