Case Study: Northern Pipe Line Corporation

I have learned the most about investing by looking at the great investments of the past. As Newton recognized, “we stand on the shoulders of giants.” And I think naturally, we would prefer to learn from those who have done great things, rather than average things.

This is my first case study in that vein. In each case study I hope to break down an investment as simply as possible, but no more so. If I have a tangent I will keep it to the footnotes or as a separate post. I hope to write in a style that anyone could understand the investment thesis, regardless of financial knowledge.

Benjamin Graham

Benjamin Graham is the father of Value Investing. His fund, the Graham-Newman Corporation was established in 1936 with an initial investment of $600,000. Over the next 20 years he returned a compound annual growth rate of 20%  turning that initial investment into $23,000,000, a 38x return over 20 years. His investment in the Northern Pipeline Corporation is a textbook example of is investing philosophy.

A Discovery

In 1926, Benjamin Graham was looking through a railroad’s annual report to the Interstate Commerce Commission. At the end of the volume he found some information about pipeline operations that had the notation: “taken from their annual reports to the Commission.” He soon found himself on his way to the Commission’s library to investigate.

Originally carrying oil to Standard Oil refineries, 8 pipelines were spun off in 1911 as part of an antitrust decision against Standard Oil. Each company was small and published limited financial information – a one line “income account” and a few lines on the balance sheet. 

While reviewing each of the spin offs, Graham’s noticed the Northern Pipe Line Corporation. What he found was a quintessential graham investment – a net-net. 

Balance Sheet Data (1926)

	Value per share
Cash and Cash Equivalents*	$79
Accounts Receivable and Inventory	$3
Plants, Property, Equipment	$34
Liabilities	$0
Share Price	$62
Current Assets	$82
Total Assets	$116

So if we simply take the value of all current, tangible and easily liquifiable assets and divide it by the share count, you arrive at a value per share of $82. At a share price of $62, the stock was trading at 25% off.

Now usually when you see this, the company has no dividend, and is burning cash quickly, say at -$20 eps a year. So the market could be pricing in the upcoming year of lost value. Let’s look at the price and earning data:

Price Data

Year	Net earnings (1000s)	Earnings per share	dividend per share	share price
1923	$308	$7.70	$25
1924	$214	$5.35	$8	$72
1925	$311	$7.77	$6	$67.5

Note: The stock has 40,000 shares of common stock. 

That was not the case here. Operations and earnings were steady, dividends per share where high, at a dividend yield (dividends per share/share price) of 8.8%.

Income Statement

	1923		1924		1925
	total (1000s)	per share	total (1000s)	per share	total (1000s)	per share
earned from operations	$179	$4.48	$69	$1.71	$103	$2.57
earned interest	$164	$4.10	$159	$3.99	$170	$4.25
nonrecurring items	$35	$0.88	$14	$0.35	$38	$0.95
total	$308	$7.70	$214	$5.35	$311	$7.77

50-70% of the earnings per year came from the earned interest on cash and cash equivalents.

Imagine you are Ben Graham, ask yourself, how much is this business worth?**

When I answers this question, I would price the business conservatively at the value per share of it’s current assets minus its liabilities: $82. I would also value the future cash flows of the business based on it’s operational earnings. In this case $2.57, at a conservative multiple of 5, that gives us $82 + $12.85 = $94.85. When priced by the market at $62, that is about a 50% difference between price and value.

This is the core of value investing. Buy an asset for less than its intrinsic value, the difference between the two is your margin of safety and expected profit.

Unlocking Value with Activism

Ben got to work. He was able to buy 2,000 shares of Northern Pipe Line’s 40,000 shares, making him the largest shareholder.

Then the challenge lied in unlocking the intrinsic value of a company, so he brought this price disparity to management. When confronted by Graham, the president of Northern Pipeline insisted that returning additional capital to shareholders was not possible: the bonds that made up most of the cash and cash equivalent portfolio were needed to cover the stock’s $100 per share par value; they needed to replace the current pipeline; and finally, they might want to extend the line in the future. In summary, he insisted that “The pipeline business is a complex and specialized business about which you know very little; but in which we have spent a lifetime. We know better than you what is best for the company and the stockholders. If you don’t approve of our policies, you should sell your shares.” [1]

Ben attended the annual meeting in January 1927 with a resolution to sell the bonds and to pay the surplus cash to shareholders. However he had neglected to bring someone to second his motion to present the memorandum, it was not read and the meeting was adjourned.

The next year, Ben had bought more shares of Northern Pipe Line and solicited proxies to vote in favor of his position. For example, he solicited the help of the Foundation which failed to intervene.

At the 1928 annual meeting, Ben came supplied with proxies for 38 percent of the shares, ensuring the election of two directors to the board. 

A few weeks after the meeting, the president agreed to liquidate the bonds and distribute $70 per share. The $70 distribution plus the remaining $30 share value of Northern Pipe Line meant that Graham unlocked value for shareholders and saw a 53% return on his $64 investment. 

Summary

The Northern Pipe Line investment is a textbook illustration of Benjamin Graham’s investment philosophy. Graham was focused on the discount, on finding safe investments that were mathematically certain and that provided a solid margin between intrinsic value and market value. Graham saw opportunity when: The Company’s Market Value < Current Assets−Total Liabilities.

Warren Buffett sometimes referred to these opportunities as cigar butts. “If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”

 Warren Buffett, Berkshire Hathaway: Letter to Shareholders (1989). 

Net-nets like Northern Pipeline are vanishingly rare in the current market (all but one cigar butt stock on the NASDAQ today has a huge cash burn rate and massive share dilution), but were bountiful  in the 1930’s bear market when security prices were depressed. 

Graham’s ideas were innovative at the time and they established key ideas about valuation that were picked up by later investors.

A few we can take away from this investment:

1. A conservative and intelligent investor should look for opportunities where a company’s market value is less than its net current asset value. This provides some margin of safety regardless of future cash flows (which we can not know for sure)
2. These opportunities exist because the market prices things separate from their intrinsic value.
3. In order for value to be unlocked quickly, a catalyst helps. In this case that was an activist investor motivating management to align with shareholders. ***

Footnotes:

*Northern Pipe Line’s cash assets were mostly in high quality railroad bonds. 
**You may also ask: What causes the discount? How can we catalyze the value of this business to reach its fair price? Would you buy shares? How much of your portfolio would you dedicate to this?

*** Buffett refers to these opportunities as control situations, where you can either control or influence the company to unlock value. I could repeat this same exercise for Buffett’s investment in Dempster Mill, but that just introduces the idea of how to value inventories, accounts receivable at a discount as compared to cash (at 100% of its value). I don’t think that’s very worthwhile.