Graham Conservative Portfolio - American Home Products and H&R Block

There is a trick that experienced engineers use when evaluating two competing technologies. You do not look at each one in isolation. You put them side by side and compare feature by feature, metric by metric. Only then does the real picture emerge.

Same method works perfectly for stocks. Two pairs of companies from the late 1960s, each telling the same story from a slightly different angle: paying too much for quality is still paying too much.

American Home Products vs. American Hospital Supply

These were two healthcare companies at the end of 1969. Both billion-dollar enterprises. Both operating in what was then called the “health industry” – a sector growing fast and printing money. On the surface, both looked excellent. Let me break down the numbers.

American Home Products had a total market capitalization of about $3.8 billion. American Hospital Supply was smaller at roughly $1.5 billion. Both companies had minimal debt – $11 million for Home, $18 million for Hospital. Both had been profitable every single year since 1958. One hundred percent earnings stability. Strong balance sheets.

So far, so similar. But the details tell the real story.

The Numbers Side by Side

American Home Products was earning $2.32 per share in 1969, up from $0.92 in 1959 – a 161% increase over ten years. Solid. American Hospital Supply earned $0.77 per share, up from $0.15 in 1959 – a jaw-dropping 405% increase. On pure growth numbers, Hospital was the clear winner.

But growth is only half the equation. Profitability matters. Home had net profit margins of 10.7% on sales. Hospital managed only 5.6%. Even more telling, Home’s return on book value was 41% – meaning for every dollar of tangible capital in the business, it was generating 41 cents in annual profit. Hospital? Only 9.5%.

Think about that for a second. Hospital was growing faster, yes, but earning less than a tenth on its invested capital compared to Home. That raises an uncomfortable question: was Hospital actually a highly profitable business, or just a mediocre business growing quickly?

What the Market Was Paying

Here is where things got interesting. The market was paying 31 times earnings for American Home Products and a whopping 58.5 times earnings for American Hospital Supply. Hospital got nearly double the P/E multiple.

The dividend yield on Home was 1.9% – modest, but Home had been paying dividends since 1919. Hospital paid a tiny 0.55% yield with a dividend history going back only to 1947.

Both stocks were trading far above book value. Home at 1,250% of book value, Hospital at 575%. Combined, investors were paying almost $5 billion in goodwill – that is, value above tangible assets – for these two companies together. Five billion dollars in pure expectations.

What Actually Happened

The conclusion for a careful investor was clear: both stocks were too expensive. Too much promise priced in, not enough margin of safety. But if you had to pick one, Home was the better deal – lower P/E, higher profitability, better dividend, longer track record.

The market, of course, had the opposite opinion. It was paying nearly double the valuation multiple for Hospital because growth rate was higher.

Then 1970 arrived. Hospital reported a small decline in earnings – just a microscopic drop. Home, the “boring” one, posted a respectable 8% gain in earnings. The market reaction was brutal and predictable. By February 1971, Hospital had fallen to $32 from $45 – a loss of roughly 30%. Home was trading slightly above its 1969 closing price.

Let that sink in. The expensive stock with the higher growth rate lost 30% of its value after a tiny earnings miss. The cheaper stock with the lower growth rate held its ground just fine. This is what margin of safety looks like in practice. When you pay 58 times earnings, there is zero room for even a small disappointment. When you pay 31 times earnings, you have at least some cushion.

H&R Block vs. Blue Bell

The second comparison is even more dramatic. On one side, H&R Block – a tax preparation company whose growth story was almost too good to believe. On the other, Blue Bell – a manufacturer of work clothes and uniforms that had been grinding out profits for decades.

Two Very Different Stories

Blue Bell was the kind of company that never made headlines. It started operations in 1916 and had been paying dividends continuously since 1923. That is almost half a century of uninterrupted dividend payments. In a competitive, unglamorous industry – work uniforms and clothing – it had become the largest player. By 1969 it was doing $202.7 million in sales and earning $7.92 million in net income, or $4.47 per share.

H&R Block was the opposite in every way. Its first published figures were from 1961, when it earned $83,000 on revenues of $610,000. A tiny operation. Eight years later, revenues had exploded to $53.6 million and net income to $6.38 million. The growth was genuinely extraordinary – 630% earnings growth from 1964 to 1969.

Valuation: Sanity vs. Euphoria

The market priced these two companies in a way that perfectly captures the difference between rational analysis and crowd enthusiasm.

Blue Bell traded at roughly $50 per share with a P/E of 11.2 – well below the S&P average of about 17 at the time. It carried a 3.6% dividend yield. Its price-to-book ratio was 142%, meaning you paid $1.42 for every dollar of tangible assets. This was a profitable, established company trading at a bargain price by any reasonable standard.

H&R Block traded at $55 per share with a P/E of 108. One hundred and eight times earnings. Its dividend yield was 0.4%. Its price-to-book ratio was 2,920% – meaning you paid $29.20 for every dollar of tangible assets. The total market value was $298 million, which was nearly 30 times the tangible assets behind the shares. For context, IBM at that time sold at about 9 times book value and Xerox at 11 times. Block was at 29 times.

Here is what makes this comparison so instructive. Blue Bell was valued at only $89.5 million – less than one-third of Block’s value. But Blue Bell was doing four times as much business, earning 2.5 times as much profit, had 5.5 times as much tangible investment, and offered nine times the dividend yield. Nine times.

The Moment of Truth

An analyst looking at Block in 1969 would have admitted the growth momentum was tremendous. The tax preparation business had obvious tailwinds. But could any reasonable person justify paying $300 million for a company earning $6.3 million? That valuation baked in decades of perfect execution with no competition emerging.

Blue Bell, on the other hand, required no heroic assumptions. It was a solid business at a reasonable price. Simple.

When the 1970 market panic hit, both stocks got hammered. Blue Bell lost about 25% of its value. Block lost about a third. Then came the recovery, and this is where it gets really interesting.

By February 1971, Block had recovered to $75 – about 35% above its 1969 closing price. Not bad for a stock that seemed absurdly expensive. But Blue Bell did even better. After a three-for-two stock split, it was trading at the equivalent of $109 – a gain of over 100% from the 1969 price.

The cheap, boring, dividend-paying uniform manufacturer crushed the high-flying growth stock. Blue Bell fell less during the panic and recovered more during the bounce. That is the margin of safety at work.

Now, there is an honest caveat here. Block still managed a 35% gain from what looked like an insane valuation. This tells you something important: selling great companies short – whether literally or just by dismissing them – is dangerous. Growth can bail out expensive valuations sometimes. But “sometimes” is not a strategy. The probabilities strongly favored Blue Bell.

What This Teaches Us

Both comparisons demonstrate the same core principle from slightly different angles.

The healthcare pair shows what happens when two similar companies trade at different valuations and reality delivers a small disappointment. The expensive one gets massacred. The cheaper one barely notices.

The H&R Block pair shows something more nuanced. Even when an expensive stock does manage to grow into its valuation, a cheap stock with solid fundamentals can still outperform by a wide margin. You do not need heroic growth rates to make money. You need reasonable prices.

There is a pattern here that repeats throughout market history. Investors fall in love with growth stories and pay 58 times earnings for healthcare companies and 108 times earnings for tax preparers. When reality delivers anything less than perfection, the punishment is severe.

Meanwhile, the stocks nobody is excited about – trading at 11 times earnings with 3.6% dividend yields – quietly deliver superior returns because expectations were set at a level reality could actually meet.

Key Takeaways

Margin of safety is not abstract philosophy. It showed up concretely when American Hospital Supply lost 30% after a tiny earnings miss while American Home Products held steady. The price you pay determines how much room you have for things to go slightly wrong.

High growth does not mean high returns for investors. American Hospital Supply grew earnings 405% over a decade. H&R Block grew earnings 630% in five years. Neither stock outperformed its cheaper peer in the period that followed. Growth is only valuable if you do not overpay for it.

Boring businesses at fair prices beat exciting businesses at unfair prices. Blue Bell made work uniforms. It had been around since 1916. Nobody wrote breathless articles about the future of uniform manufacturing. And it delivered over 100% returns while the market darling struggled to recover from a 33% drawdown.

High return on capital is great, but it does not justify any price. American Home Products earned 41% on book value, which is extraordinary. But even that excellent profitability did not make the stock a screaming buy at 31 times earnings. Both healthcare stocks were too expensive for a truly conservative investor.

The pair comparison method reveals what single-stock analysis hides. Looking at H&R Block alone, the story was compelling. Looking at it next to Blue Bell – with four times the revenue, nine times the dividend yield, and one-third the market cap – the overvaluation became impossible to ignore. Always compare.