Graham Defensive Picks - REITs and Air Products at Discount

One of the most useful exercises in investing is putting two similar companies next to each other and asking a simple question: which one do I actually want to own? Not which one has the better story. Not which one is growing faster. Which one gives me the best chance of not losing money while still making a decent return?

This kind of side-by-side comparison strips away the noise. Same industry, similar products, roughly the same market conditions – and yet one company is run conservatively and the other is a ticking time bomb. When you see it laid out in numbers, the difference is obvious. Most investors never bother to do this. They chase the exciting name and wonder later what went wrong.

Let me walk through two case studies that demonstrate this approach.

The REIT That Was Actually Named REIT

In the 1960s, there were two real estate companies trading side by side on the American Stock Exchange with almost identical ticker symbols. One was Real Estate Investment Trust – yes, a REIT literally named REIT, ticker REI. The other was Realty Equities Corporation of New York, ticker REC. Easy to confuse the two. But that is where the similarity ended.

Real Estate Investment Trust was a staid New England operation. Three trustees running the show. Operations going back nearly a century. Continuous dividend payments since 1889. They stuck to prudent investments, grew at a moderate pace, and kept their debt at levels they could easily handle. Boring. Predictable. The kind of company that never shows up in a cocktail party conversation.

Realty Equities was the opposite. In eight years, the company blew up its asset base from $6.2 million to $154 million. Debt grew in the same proportion. But here is the really alarming part – they did not just expand in real estate. They went on a buying spree that had nothing to do with their core business. Two racetracks. Seventy-four movie theaters. Three literary agencies. A public relations firm. Hotels. Supermarkets. A 26% interest in a cosmetics company that later went bankrupt.

This is what happens when management gets addicted to deal-making. They stop asking “is this a good investment?” and start asking “can we close this deal?” Very different questions.

The Numbers in 1960

In 1960, the Trust was clearly the more established business: $3.6 million in gross revenues, $485,000 in net income, total assets of $22.7 million against $7.4 million in liabilities. Book value per share was $20. Total market value of common stock was about $12.2 million.

Realty Equities was much smaller. Gross revenues of $1.5 million, net income of $150,000, total assets of $6.2 million. But the red flag: liabilities were already $5 million against just $1.2 million in book value. Leveraged to the eyeballs from the start. Market value of common stock was $1.36 million – about nine times smaller than the Trust.

Then Realty Equities Went Wild

By 1968, Wall Street had fallen in love with Realty Equities. The stock shot from $10 to $37.75. Warrants went from $6 to $36.50. Combined trading volume hit 2.4 million shares. Meanwhile, the Trust shares moved sedately from $20 to $30.25 on modest volume. Nobody writes newspaper articles about a stock going from $20 to $30.

But look at the fundamentals. The Trust’s book value was $20.85 per share. Realty Equities’ book value? Just $3.41 – less than a tenth of its high price that year. The market was valuing Realty Equities at roughly ten times what the company was actually worth on paper.

Realty Equities had racked up over $100 million in debt through at least six different kinds of obligations – mortgages, debentures, public notes, bank notes, loans and contracts payable, and SBA loans. They also had a preferred stock with $7 annual dividends but a par value of only $1. The capital structure was a maze designed to confuse, not to inform.

The Inevitable Collapse

The next year, the price fell to $9.50. Then came the report for March 1970. The company posted a net loss of $13.2 million – roughly $5.17 per share. That basically wiped out the shareholders’ already slim equity. This included an $8.8 million reserve for future losses on investments, meaning management knew more bad news was coming.

The directors still declared an extra five-cent dividend right after the fiscal year closed. As if everything was fine. The auditors refused to certify the financial statements. The stock got suspended from the American Stock Exchange. In the over-the-counter market, the bid price dropped below $2.

The Trust? It dipped to $16.50 in 1970 – a normal correction – then recovered to $26.63 in early 1971. Latest earnings were $1.50 per share. Stock was selling modestly above its book value of $21.60. Shareholders had been served honestly and well.

What Went Wrong at Realty Equities

Three things killed this company, and they kill companies to this day.

First, the capital structure was absurdly complicated. Preferred stock, warrants, six types of debt – this level of financial engineering almost always signals that management is hiding something or playing games with leverage. If you cannot understand how a company is financed in fifteen minutes, that is not sophistication. It is a warning sign.

Second, the company diversified into businesses it had no expertise in. Literary agencies? Public relations firms? Cosmetics? This is the opposite of focus. Sometimes people call this “di-worse-ification” and the name fits perfectly. Management was spending time learning new industries instead of getting better at real estate.

Third, growth was funded entirely by debt. Going from $6.2 million to $154 million in assets is impressive until you realize that liabilities grew in exact proportion. Nothing was built on a foundation of actual earnings. It was all borrowed money, and borrowed money has a nasty habit of needing to be paid back at the worst possible time.

Air Products vs. Air Reduction – Growth vs. Value

The second comparison involves two direct competitors in industrial gases: Air Products and Chemicals, and Air Reduction Co. Same industry, similar products. But the market priced them very differently.

The 1969 Snapshot

By the end of 1969, Air Products shares traded at $39.50 with about 5.8 million shares outstanding, giving a total market value of $231 million. Air Reduction traded at $16.38 with 11.3 million shares, giving a market value of $185 million.

So Air Products – the smaller company by revenue – was valued 25% higher than its bigger competitor. Why?

Air Products had the better growth story. Earnings per share grew from $0.52 in 1959 to $1.51 in 1964 to $2.40 in 1969. That is a 362% increase over the decade. Air Reduction went from $1.95 to $1.51 to $1.80 over the same period – actually a decrease from ten years earlier, though there was a bounce-back in the last five years.

Air Products also had higher profitability: net margin of 6.2% versus 4.25% for Air Reduction. Return on book value was 11% versus 8.2%.

The market responded exactly how you would expect. Air Products traded at 16.5 times earnings and 165% of book value. Air Reduction traded at just 9.1 times earnings and 75% of book value. You could buy Air Reduction for twenty-five cents on the dollar less than its stated net worth.

But Cheaper Had Advantages Too

Air Reduction was not just cheap on paper. It had real financial strengths that growth investors were ignoring.

The dividend yield was 4.9% versus just 0.5% for Air Products. If you needed income from your portfolio, this was a massive difference. Air Reduction had been paying dividends since 1917. Air Products only since 1954.

The balance sheet was stronger too. Air Reduction had a current ratio of 3.77 – current assets nearly four times current liabilities. Air Products was at 1.53. Working capital to debt was 0.85 for Air Reduction versus just 0.32 for Air Products. By any measure of financial safety, Air Reduction was in better shape.

Who Won?

During the 1970 market break, Air Products declined 16% while Air Reduction dropped 24%. If you stopped the clock there, the growth stock “won.” It held up better in a downturn, which is what you would expect from a higher-quality, higher-priced stock.

But then came the recovery in early 1971. Air Reduction rose 50% above its 1969 closing price. Air Products gained 30%. The cheap stock gave back more in the crash but then snapped back harder. On a round-trip basis, the low-multiple stock outperformed.

This pattern is not unique to these two companies. It shows up again and again. Value stocks – cheap, boring, low-multiple ones – tend to bounce back harder from corrections than their expensive, glamorous peers. Over full market cycles, they often come out ahead precisely because the starting price was more reasonable.

The Real Lesson

The question was never “which is the better company?” Air Products was clearly the better business. Higher growth, higher margins, higher return on equity. Nobody disputes that.

The real question was “which is the better investment at these prices?” And that is a fundamentally different question. A great company at a crazy price can be a terrible investment. A mediocre company at a bargain price can be a great one. The gap between quality and price is where the money is made or lost.

The investor buying Air Reduction was saying “this is a good enough business at a price that gives me a margin of safety.” And the numbers proved them right.

Key Takeaways

Simple capital structures beat complicated ones. When a company has six types of debt, warrants, exotic preferred stock, and treasury share maneuvers, run the other direction. Complexity in corporate finance almost always benefits management, not shareholders.

Diversification into unrelated businesses is a red flag. A real estate company buying movie theaters and literary agencies is not diversifying risk. It is spreading management attention across areas where they have no competitive advantage. Stick with companies that do one thing well.

Debt-fueled growth is growth on borrowed time. Growing assets from $6 million to $154 million sounds impressive. Growing liabilities in the same proportion is terrifying. Real growth comes from earnings, not from loading up on leverage.

Cheap stocks bounce harder. In full market cycles, low-multiple stocks tend to outperform high-multiple stocks. They fall more in crashes, but they recover more aggressively. The math works because you start from a lower price relative to real business value.

The best company is not always the best investment. This is maybe the hardest lesson for most investors to accept. You can acknowledge that one business is clearly superior and still choose to invest in its cheaper competitor – because the price difference more than compensates for the quality difference. Investing is not a beauty contest. It is a math problem.