Black Thursday 1929 Crash

Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

A week ago, I recommended a now-out of print book from 30 years ago that was an academic study of the Great Depression called The Crash and Its Aftermath.  It is, hands down, the most useful statistical survey of the Great Depression and the 1929-1933 period I have ever read.  It instantly ranks up there with Security Analysis in terms of providing actual, real world, case study data so you can see what happened.  Consider the insanity of the 1929 stock market.  Prior to the crash, the bank stocks were among the most overvalued relative to earnings and assets.  On page 50 and 51, the author examines the data he’s compiled in the appendices:  

The nine largest at their highest stock prices averaged 53 times 1929 earnings per share, 523% of book value, and a dividend yield of only 1.42%.  The banks had no earnings history to justify such valuations.  Profits for 1929 for the banking industry were a record $729 million, but for the nine leading companies return on equity averaged only 10.2%, compared with 16 1/2% for all companies, and the banks’ history was one of stability rather than rapid growth.  Their high stock prices were stimulated entirely by intense merger activity among banks in 1929 and by the trading of their own securities affiliates.

The railroads were also another interesting case study.  On pages 34-36, he examines those.  I am going to highlight some of the most important passes, without notating the edits here for space:

Railroads constituted the largest U.S. industry by a considerable margin.  The market value of all railroad stocks was $10.1 billion on October 1, 1929, compared with the value of all NYSE stocks of $79.1 billion.  The railroad industry had done reasonably well in the late 1920s.  Industry net income was a record $883 million in 1926, down slightly in 1927 and 1929, and up to another record in 1929 of $977 million.  The nine leading railroad companies averaged a 9.7% return on equity in 1929, and their 1929 dividends appeared well protected by earnings per share more than double their dividends.  

Rail stocks were widely considered income stocks bought for their dividend yield.  The average yield of the nine leading railroad stocks was 3.57% at their 1929 highs, compared with the broad stock average of 3%.  Most of the railroads had very stable dividends.  An irony of the railroads’ situation was that despite their position as income investments they paid out a low proportion of earnings in dividends.  The dividend rates of the leading railroads averaged only 51% of net income, compared with the average for all industries of 67%.  Only oil, chemical, and heavy manufacturing companies came close to the railroads’ low dividend payout ratios.  Unlike the railroads, however, which had not expanded their tracks, locomotives, or passenger cars since 1914 and had barely expanded their freight car capacity, these other companies generally needed their income to finance growth.  The railroads were forced to retain a high proportion of net income because of their low return on equity, poor cash flow, and difficulty selling common stock.  They were already too highly leveraged, with 40% debt, whereas many retail and industrial companies had no debt and utilities kept their debt below 40%.  The capital necessary simply to stand still dictated railroad dividend policies rather than opportunities for growth.

That is one of the reasons “owner earnings” – a figure that is more complex and involves adjusting net income for capital expenditure maintenance charges and other factors – is more important than reported net income alone.  In this case, the owner earnings of the railroads would have been far lower than the net income, so the stocks would have appeared even more overvalued than they were.

[mainbodyad]The thing that makes the game interesting was pointed out by Dr. Jeremy Siegel in The Future for Investors.  Over the past half century, despite all of these problems, railroad stocks have actually beaten the stock market as a whole.  The reason?  Investors hated them so much following the 1930s and 1940s that the valuations fell to levels cheap enough that it didn’t take much to provide very lucrative returns to equity investors, even if the underlying businesses were still somewhat challenged.  In his book, Siegel pointed out that, despite falling revenues, “rail productivity has tripled since 1980, generating healthy profits for the carriers.”  Burlington Northern Santa Fe became so efficient it generated 17% annual returns for nearly 30 years.

Public utility holding companies were another area where people lost their collective minds.  The turnover in shares was more than 100%, meaning people weren’t buying the investment to profit from the underlying business, but speculating on the future price of the stock.  At the top of the market, these power and gas giants traded at an average 57 times earnings, 444% of book value, and offered a pathetic dividend yield of 0.87%.  Return on equity was only 9.5%.  

What about oil companies?  Those were interesting stocks as well at the start of the Great Depression in 1929.

Despite the size and growth of the oil industry, oil company stocks were on a par with railroad and steel company stocks as the lowest-valued stocks in the market.  The ten leading oil company stocks at their high prices averaged only 17 1/2 times 1929 earnings per share and 161% of book value, compared with the averages for all companies of 30 times earnings per share and 420% of book value.  Oil stocks yielded a relatively high 3.45%, compared with 3% for all stocks.  The cause of the poor valuation of oil stocks was the companies’ low return on equity, which averaged only 9.7% in 1929.  Even the four leading Standard Oil companies averaged only 9 1/4% return on equity.

The 17.5x earnings might sound high, but oil stocks had been suffering from oil falling to $1.70 per barrel in October of 1929 (down from $2.24 per barrel in 1926) and gasoline to 7.5¢ per gallon (down from 15¢ per gallon in 1925).  This happened due to the discovery and tapping of large oil reserves, which drove down the prices on the commodity markets.  

Black Thursday 1929 Crash

According to Wigmore’s research in The Crash and Its Aftermath, “At their peaks the banks were probably the most overvalued stocks in the market. National City Bank stock traded at 120 times 1929 earnings per share and over 1300% of book value. Chase National Bank stock traded at 62 times 1929 earnings per share and 438% of book value.”  When the selling started, panicked speculators had no choice but to look on – the ticker tape was delayed and people couldn’t find out the prices at which they bought or sold shares until hours after the trade had taken place – helpless.  As horrible as it sounds, it was deserved.  What other possible end could have come from buying a large, established bank at an earnings yield of 0.83% at a time when corporate bonds backed by real assets were offering up to 6.00%, and then not paying cash but borrowing $9 for every $1 of your own you kicked in for the purchase?  Oh, and not just using that 10-1 leverage – using debt that could be called at any time, for any reason, by the person who lent the cash to you!

As for the market itself, the typical business traded at 30x current year earnings in 1929, which were themselves at record high profits.  At the same time, good quality corporate bonds, backed by actual tangible assets that could be seized in bankruptcy court to provide collateral for the loan, were yielding twice what you could achieve from the earnings yield stocks.  

That is the definition of financial stupidity.  No rational person could justify writing a check, or continuing to hold, an enterprise with the characteristics of a public utility holding company at those prices.

The price you pay matters.  In the real-world case study I gave you a few days ago, I showed how the valuation differential of two businesses – Kellogg’s and IBM – is fairly stark when you begin thinking this way.  If you get the starting price right, and its backed up by actual profit and assets, you can sit by in an Great Depression and be content to know you’re probably going to be fine, especially if you hold a wide collection of investments, some of which aren’t in the stock market.

The Great Depression Was Not an Indictment of the Stock Market, It Was an Indictment of Human Stupidity and Avarice

We act like the Great Depression was some horrible human tragedy because of all of the suffering – and in a sense, it was.  But it was deserved.  A significant portion of the investing public had lost all connection to rationality and devolved into greed on a scale that wasn’t seen again until the go-go era of the 1960s and, later, the dot-com boom of the 1990s.  It was pure, unrestrained avarice fueled by excessive debt.  Someone who bought in at the top and saw his holdings go down 90% didn’t “lose” 90% because that top valuation was never real.  It was fiction; an illusion with no connection to the source of the value – namely, how much cash the asset pumps out for you to spend, give to charity, reduce debt, reinvest, or save.

To be more direct about it: If you were buying bank stocks, or railroad stocks, or public utility holding company stocks, at those valuations, you deserved to suffer horrific losses.  There was no other alternative except the market treading water for a decade (which is what happened following the 1990’s) as the profits caught up the valuations.  The crash was not an indictment of the market, it was vindication of it.  

[mainbodyad]The investors who did pay attention to valuation, and reinvested their dividends during the crash, only took a few years to break even again, despite the stock market index itself not reaching its former high for 25 years.

I cannot recommend this book highly enough.  The Crash and Its Aftermath has instantly earned a spot among my top 5 investing books, and one that will remain with me in my office for the rest of my life.  I don’t think any serious investor, or student of finance, should be without a copy in his or her library.  It’s that good.  It makes you realize just how horrible things can get – many companies lost 50% of their value in only two days – and that understanding can help you better arrange your life to survive just fine if that were to ever occur again.  Statistically, it almost assuredly will.  It’s just a matter of whether or not you, and your family, are prepared for it.