I have always been of two minds about financial research. For the good of society, my science and engineering background has shouted out to publicize any advances I thought I made. For the good of my clients and my practice, my brain told me to keep advances secret. I have decided on a compromise. This is the first of a series of notes on improving financial results without giving out the unique features of our strategies.

It was called the biggest bankruptcy ever. In June 1970, the Penn Central Railroad, due to corporate and regulatory mismanagement, went into bankruptcy. Penn Central was the largest corporation in Pennsylvania — a state with many major corporations such as U.S. Steel, Bethlehem Steel, and a number of coal and oil giants. It is said that the Pennsylvania legislature ended each session with the announcement, “If the Pennsylvania Railroad has no further business, this session is adjourned.”

By 1977 the U.S. government had purchased both the freight and passenger rail lines from the bankrupt Penn Central. This left the corporation with a number of assets, including valuable real estate such as Madison Square Garden. The bankruptcy judge announced that the Penn Central had filed a plan to pay creditors 90% of their claims. Creditors had 90 days to object. If there were no objections, the plan would be accepted and the bankruptcy would end.

There was very little news coverage. Americans were interested in growth investments, not failed ones. The news articles made the point that railroad bankruptcies generally took 30 years, so do not pay much attention to the announcement. I noticed two things. First, there was no longer any railroad involved. And secondly, the bonds were selling at 30% of face value. I started to recommend and purchase the bonds.

The judge did not cooperate. After each complaint period ended without any objections, the judge gave creditors another 90 days to review the plan. Finally, one year later, the judge said, “There being no objections, the plan is approved.” We received our $900 for bonds we purchased between $300 and $500. About ten minutes after the judge approved the plan, it finally dawned on me what the judge was doing. He was saying in the only way he could legally say, “Ask for 100% payment for your debt obligations. The Penn Central has the funds, and I will at least consider it.” NO ONE did.

The efficient market theory says that wherever inefficiency in the market occurs, investors will find it, capitalize on it, and drive the price to its appropriate level. Those who do not believe in the theory tell this story. An economics professor and his student are walking across campus. The student points to the ground and says, “Look professor, a twenty-dollar bill.” The economics professor says, “No, it cannot be. If it were true, someone would have picked it up already.”

The Lesson… You can beat the market. The fact that no one took the opportunity to increase their returns in the Penn Central case led me to believe that there are other opportunities in which you can be the only one — or one of a few — who will find anomalies in the market that can be very profitable.

Sincerely,

Katz Family Financial