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Notes – The Aggressive Conservative Investor

The Aggressive Conservative Investor

by Marty Whitman, published 1979, 2005

A seeming contradiction in terms

The following note outline was rescued from my personal document archive. The outline consists of a summary of Marty Whitman’s classic value investing tome, The Aggressive Conservative Investor.

Chapter 1, An Overview

  1. Two main types of investors
    1. passive, outsider investors
      1. no control over the management of their investments
      2. no knowledge of the investment other than what is publicly disclosed
    2. activist, insider investors
      1. have control over the management of the investments
      2. privvy to non-public information and disclosures
  2. Two major types of businesses which require two different kinds of analysis
    1. strict, going-concern
      1. large, stable institutions which tend to sell the same product and finance the selling of it in similar ways over time
    2. asset-conversion firms
      1. merger/acquisitions
      2. the purchase and sale of assets in bulk
      3. major financial restructurings or recapitalizations
      4. sales of control or contests for control
      5. creation of tax shelter entities
  3. Key emphasis is placed upon financial position
    1. ability to create liquidity (from cash or from liquid assets)
    2. ability to borrow
    3. ability to generate surplus cash from operations
    4. ability to market new equity securities
  4. In contrast, conventional fundamental analysis focuses on primacy of earnings
    1. reported earnings are a fundamental determinant of stock price
    2. this primacy of earnings theory is emphasized only in special circumstances where the company is a strict going concern or when its securities are being studied via day to day share price fluctuations
    3. most securities holders are not stock traders
    4. most businesses are not strict going concerns
    5. financial position reveals itself to be a better long-run determinant of valuation because it more fully represents the character of the underlying business
  5. Concerned with fundamental rather than technical analysis
  6. What is a security?
    1. investment vehicle which allows the holder to benefit from an inactive creditor or owner role
    2. examples: common stocks, preferred stocks, bonds, leasehold interests, limited partnership participations, savings-bank deposits and commercial paper
    3. example of a non-security: fast food franchise agreement which requires the owner to participate as manager as part of the agreement
  7. Understanding the underlying business becomes increasingly important as larger amounts of funds or increasing proportions of the individual’s resources are invested in a security
  8. Additionally, understanding the business is increasingly important with diminishing seniority within the security hierarchy, which exposes the investor to increasing risk
  9. The book takes a broad perspective on the strategies and perspectives of numerous types of investors because understanding the motives of others can highlight specific opportunities and risks for the individual investor himself
  10. Emphasis is on “business internals” rather than market and economic externals
    1. most individuals have little ability to predict the latter
    2. keen awareness of the former can remove a lot of the risk from the equation and protect the investor from mistakes made about the latter
  11. Disagree with modern capital theorists
    1. most markets and common-stock prices are in disequilibrium
    2. careful and thorough perusal of publicly available documents can guard the individual from unsystematic risk
  12. Underlying conviction that the value of a business has no necessary relationship to the price of its stock
  13. The primary determinant of future earnings and common-stock prices is financial position; quality and quantity of a business’s resources
  14. “Magic formula” for investment success is not arithmetic but grows out of:
    1. experience
    2. insight
    3. maturity of judgment
  15. Three general topics covered by the book:
    1. educate outside investors about the way insiders and deal promoters tend to think
    2. help the outsider to gain familiarity with the uses and limitations of required disclosures of the SEC
    3. attempt to impart understanding about the roles of the various players in the financial community and how they each participate in the investment process
  16. Focus on four types of investments to be made in commercial paper, corporate bonds, certain leases, preferred stock, limited partnership interests and common stocks:
    1. trading investments
    2. investments in the securities of emerging companies or industries
    3. workout and special-situation investments
    4. cash-return investments

Chapter 2, The Financial-Integrity Approach to Equity Investment

  1. Successful investors-activists prioritize their concerns as the potential issuer of a loan would:
    1. First, how much can I lose?
    2. Second, how much can I make?
  2. Strong financial positions generally translate to:
    1. less risk
    2. greater ability to expand business
    3. more attractive candidate for asset-conversion activities
  3. Attractive equity investments for outsiders should have the following characteristics:
    1. strong financial position, measured not so much by presence of assets as by the absence of significant encumbrances
    2. run by reasonably honest management and control groups that are aware of the interests of creditors and other security holders
    3. availability of a reasonable amount of relevant information, necessarily falling short of “full disclosure”
    4. price out to be below the investors reasonable estimate of net asset value
  4. Primary motivation for buying is that values are “good enough”, no search for bottoms in the short-run
  5. Shortcomings of the Financial-Integrity Approach
    1. requires an enormous amount of work; sifting through documents
    2. know-who is helpful and at times essential; special information discernible only from non-public relationships
    3. the most attractive securities uncovered by FIA tend to be in inactive markets, especially post-arbitrage
    4. risk aversion results in a severely limited selection of attractive securities which might be fully enjoyed by the less risk-averse
    5. securities issued by those believed to be “predators” should be avoided
    6. FIA approach is mostly useless in areas where sufficient public disclosure can not be obtained
    7. insiders sometimes pose a risk to outsiders and because of their ability to force-out outsiders and independently appraise values, some attractive opportunities will be avoided by the FIA adherent
  6. FIA view of risk
    1. quality of the issuer
    2. price of the security
    3. financial position of the holder

Chapter 3, The Significance of Market Performance

  1. Stock market value should be weighted differently for different individuals
    1. traders; 100% because they are trading for capital appreciation
    2. investors seeking secure income; 0%, because they may want to acquire a larger position over time at lower prices
    3. vast majority of people; somewhere considerably more than 0 and considerably less than 100
  2. Investors who do not weight stock prices as 100% important:
    1. investors who would benefit from low market valuations for estate tax or personal-property tax purposes
    2. investors primarily interested in maximizing cash return and/or are continually creating cash for new investment from non-investment sources
    3. investors seeking to accumulate large positions for control or to influence control shareholders
  3. One can not beat the market by trying to beat the market; instead, long-term performance comes from buying clear values and holding them in the absence of clear evidence that a mistake has been made
    1. evidence for this mistake comes in the results of the business, not the market’s valuation of the business
  4. Market performance is more important to a portfolio of fixed size or facing continued withdrawals of cash; less important to a portfolio which is a continual recipient of new cash and is thus a dollar-averager
    1. for the dollar-averager, good market perf results in less attractive terms for continued investment, bad market perf leads to more attractive terms for continued investment
    2. dollar averaging diminishes the need to beat inflation because changes in the value of money, in the long-run, will be offset by changes in the return on securities
    3. example; a well-run fire and casualty insurance company, which receives continuous cash injections from underwriting department
  5. An outside investor holding a completely marketable security should give a weighting of close to zero to market perfomance when:
    1. he knows has reason to believe that the security’s real worth is not close to the market price
    2. he knows he will not need to liquidate in the near future
    3. he knows he will not need to use the security as collateral for borrowings
  6. Important to remember that stock market prices are not business or corporate values but a realization price that will likely not hold in the event of a merger or acquisition; market price is a value of only part of the total outstanding, not all outstanding stock
  7. Comparative measures of portfolio performance are imprecise; a company can beat its industry benchmark but still have performed poorly in an absolute sense, or vice versa
  8. Professional money managers and beating the market
    1. some economists believe that the goal of professional money mgrs is to beat the market and they have failed if they don’t
    2. many professional mgrs have other concerns than simply beating the market:
      1. maintenance of cash income
      2. maintenance of cash principal
    3. for example, is it important that a strongly capitalized insurance company outperform the market when its net investment income is increasing at 10% annualized?
  9. Investors seeking “bailouts” from their investments might weight market performance low
    1. control of a company can allow for control over cash bailouts through dividend policy, mgmt of salaries and fees
    2. control of a company can allow for non-monetary bailouts via three P’s
      1. power
      2. prestige
      3. perquisites
  10. Three types of security holders who rate market performance highly, seeking “bailout” in the market:
    1. common stock holder with minority interest in which dividend income is insignificant or not part of the objectives
    2. control stockholder and company seeking to sell securities or issue them in merger and acquisition transactions
    3. holder without a strong financial position; someone who intends to borrow or has borrowed heavily to finance his portfolio

Chapter 4, Modern Capital Theory

  1. Description of MCT and efficient portfolios
    1. an individual knows how he reacts to risk and must choose from stocks, bonds and cash
    2. he evaluates each instrument accurately in terms of risk, expected return and relative valuation/price movement
    3. assuming all assumptions are accurate, the individual creates a portfolio that provides the largest expected return for a given level of risk
    4. this best describes the environment faced by the stock trader
    5. this theory fails to account for thin markets, price formation mechanisms, non-symmetric information and general equilibrium considerations
    6. this theory is not suitable for outside investors primarily interested in income, dollar averaging or special-situation investors who ignore timing considerations, as well as all activist investors
    7. MCT also assumes the avg outside investor and his adviser are capable and able to interpret information correctly; empirical evidence points to the opposite
  2. The computer and mathematical analysis
    1. the fatal flaw of mathematical analysis is the non-quantifiable variables or ugly facts that get left out of the models assumptions
  3. On systems for playing the market
    1. Chartist-approach
      1. Not necessarily irrational or illogical
      2. Movements of the market do represent aggregate behavior, however, to date no truly successful chartist model has been created
    2. Random-walk theorists
      1. at any instant, price changes follow no predictable pattern
      2. using only trading information, there is no predictability to prices
    3. filtering rules or formula-timing
      1. best that can be said is their mechanical application can save investors from getting suckered into go-go markets or being rushed out the exits by mass panic
  4. On arbitrage
    1. topic for a professional, requires plenty of calculation and minimization of trading costs (should be a member of an NYSE firm)
    2. Thorpe and Kassouf’s book is recommended
  5. Portfolio balancing
    1. “Beta” is the estimated market sensitivity of a stock, measured in terms of an expected incremental percentage return associated with a one percent change in return of the S&P500
    2. For the avg investor, problems occur far more often with security analysis than portfolio selection
    3. Most important for someone running many millions of dollars; for everyone else, this is over-rated; all the best portfolio-balancing in the world won’t save you from poor analysis
  6. Fundamental security analysis and corporate finance
    1. Good fundamental analysis involves perception, training, understanding and a high degree of abstraction in implicit or explicit model building– picking the right variables and causal relations
    2. There are far fewer skilled practitioners than there are opportunities to practice security analysis
    3. The idea that fundamental analysis is not necessary because markets are efficient is flawed because most analysts are incompetent, which prices ultimately reflect
  7. Calculation or evaluation
    1. The problem facing any serious analyst is what the figures mean, not what they happen to be
    2. For example, imagine a company carrying real estate on its books at $1.5M; the significance changes when we learn that they represent 100,000 acres of California coastal land carried at the 1880 purchase price
    3. Valuations change depending upon the context of valuation; estate planning, income taxes, obtaining a loan, etc. all produce different valuations of the same entity

Chapter 5, Risk and Uncertainty

  1. The outsider faces greater risks than the insider
    1. he cannot acquire complete knowledge of a company, no matter how many documents he studies
    2. he (and the insider) face the possibility that the analysis is wrong
    3. he may fail to properly appraise the quality and honesty of the management
    4. he may simply fall prey to the unpredictability of the future
    5. the market may fail to realize intrinsic value for extended periods of time, even if the analysis of those values is correct
  2. Assessing the investment odds: risk and reward
    1. conventional wisdom states that the key to investment risk is the quality of the issuer
    2. high quality issuers tend to be well-known, and this knowledge is reflected in asset prices
    3. therefore, the cliche, “You have to take chances if you want to make money”
    4. but financial position of the security holder and the price of the issue are also important factors in judging risk and reward
  3. Quality of the issuer
    1. A company can become high quality just because important people within the investment community say it is; they’re often proven wrong
    2. never buy when a high quality company is being touted because it is probably overpriced then
    3. if your investment matters to you, obtain at least a rudimentary knowledge of the company before investing
  4. Price of the issue
    1. Good investors focus on how much they can lose; “risk averse”
    2. higher price translates to higher risk, lower price, lower risk
    3. there can be considerably lower risk investing in a lower quality company at a lower price than at a higher quality company at a higher price
    4. an investor with more time and expertise to spend on his analysis should weigh price considerations more heavily; an investor with less time and less expertise should weigh quality considerations more heavily
  5. Financial position of the holder
    1. an investor who buys the best quality stock at a fraction of its overall value is taking a significant risk if he can’t afford the purchase
    2. investors on margin can turn high quality investments (such as USTs) into speculative gambles
    3. investors often take losses when they do not have enough funds to live on and are forced to liquidate at an inopportune time
    4. without the resources to ignore them, an investor has no guard against stock-price fluctuations
  6. Portfolio diversification versus securities concentration
    1. diversification is a way to reduce risk in situations where the investor lacks knowledge
    2. in situations where the investor enjoys enough knowledge, confidence and financial position to weather temporary setbacks, the risk-reward ratio may be tipped in favor of concentration
  7. Considering the consequences
    1. The astute investor examines consequences as well as odds
    2. The odds can be strongly in favor of appreciation/success, but the consequences of failure so severe (insolvency) that the risk-reward ratio is still not in favor of making an investment
  8. Risk and investment objectives
    1. The cash-return investor will base his investment decision on different factors in evaluating risk than the special-situation investor, even when using the same facts
    2. Risk-reward ratio will provide the investor with a guide to use in defining his investment objectives
    3. Cash-return investors with no opportunity to investigate carefully should focus primarily on quality of the issuer
      1. reference bond rating services
      2. reference the investors own independent conclusions
      3. any doubts, don’t invest; sell if owned
      4. should limit investments to debt securities in most instances
        1. debt securities have a legally enforceable right to be paid principal and interest
        2. higher up in the capital structure in the event of an insolvency
    4. workout- or special-situation investor should focus on price of the issue
      1. he finds safety in a low price
      2. place important emphasis on the four elements of the FIA

Chapter 6, Following the Paper Trail

  1. Principle documents of the paper trail:
    1. Form 10-K; official annual business and financial report
    2. Form 10-Q; quarterly financial report, includes disclosures of certain material and extraordinary events that occurred during the three-month period
    3. Form 8-K; filed within 15 days of a reportable event, unscheduled material events or corporate changes
    4. Annual reports; most important way most public companies communicate with shareholders
    5. Quarterly reports
    6. Annual-meeting proxy statements; used to solicit votes of shareholders
    7. Merger proxy statements; issued to shareholders to vote on an asset conversion-matter such as merger, consolidation, sale of assets or liquidation (S-14)
    8. Prospectuses; registration statements issued when securities are being offered publicly (S1 & S7)
    9. Cash tender offer circulars; sent when a publicly announced offer is made to buy shares for cash
    10. Encumbrances are almost always spelled out in these documents and their footnotes
  2. The documents and how to read them
    1. Simply reading these documents will give you a good idea of whats contained within and what their use is
    2. If you can obtain copies of the preparation documents used to create the SEC officially regulated forms, you can get an idea of what the preparer has to consider in making disclosures
    3. Other important documents
      1. Forms 3 and 4; disclosure by insiders concerning their shareholdings and changes in holdings
      2. Form 144; filed by holders desiring to sell restricted stock under Rule 144
      3. Form 13F; filed by all managers with accounts of marketable equity securities greater than $100,000,000
      4. Schedules 13D; filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or, who acquire an additional 2 percent within a 12 month period after already acquiring 5 percent)
      5. Schedules 14D; similar to 13D, filed prior to making a cash tender offer for more than 5% of shares outstanding
    4. What the paper trail doesn’t do
      1. does not provide company forecasts, company budgets and valuation appraisals of assets
      2. no real disclosure as to specifics of running the business, such as appropriate levels of capital expenditure, marketing, research and development, etc.
      3. might miss small acquisitions that do not require a shareholder vote

Chapter 7, Financial Accounting

  1. Types of accounting
    1. cost (or control or managerial)
      1. purpose is to tell a management what its costs are
      2. internal, essential to the operation of the business
    2. income-tax
      1. not supposed to measure economic reality, unlike cost-accounting
      2. designed to create an economic reality (tax bill) based on rigid set of principles (Internal Revenue Code)
      3. emphasis is on minimizing tax exposure
    3. financial
      1. sandwiched between cost accounting and income-tax accounting
      2. “primary purpose is to provide quantitative financial information about a business enterprise useful to owners and creditors”
      3. seeks to “fairly” represent the results of operations and the financial position of the company
  2. How to understand financial accounting, five major misconceptions:
    1. no need to distinguish between financial accounting versus income-tax and cost accounting
    2. financial accounting has much the same role in corporate analysis and in stock market analysis
      1. primary emphasis in corp analysis is on what numbers mean, not what they are
      2. in corp analysis, no rule that one accounting number is more important than any other; in stock market analysis, primary emphasis tends to be put on net income/earnings per share
      3. in corp analysis, profit is thought to come from the business factors themselves; stock market analysis, profit comes from what one thinks someone else will pay for the security later
      4. because stock market analysis doesn’t rely on deep understanding of the underlying business, value is sought elsewhere– in precise attainment of estimated numbers
    3. accounting can be made distortion-free an/or realistic and/or uniform
      1. financial accounting is based on Generally Accepted Accounting Principles
        1. an attempt is made to match revenues with costs on an accrual basis to the exclusion of matching cash inflow with cash outflow
        2. an attempt is made to view businesses on a going-concern basis
        3. financial-accounting is primarily based on exchange prices
        4. financial-accounting is primarily based on historical costs
        5. financial statements are designed to be general-purpose, “serve the common needs of a variety of groups”
      2. as a result, financial-accounting can not be distortion-free, realistic or uniform
      3. financial-accounting is more useful at measuring the economics results and values rather than the solvency of a business
        1. more useful for judging a strict going-concern
        2. less useful for a natural resource company, real estate or life insurance companies or companies engaged in mergers, acquisitions and imaginative financing and refinancing
        3. as an example, most high quality real estate that is well-maintained doesn’t depreciate over time, but it has to for tax and accounting purposes
    4. about the meanings of GAAP
      1. inter-industry distortions arise based upon calling similar circumstances “permanent differences” or “timing differences”
    5. about the shortcomings of the corporate audit function and the ethical standards of independent auditors in the US

Chapter 8, Generally Accepted Accounting Principles

  1. Myths and realities about the meaning of GAAP
    1. Myth #1; GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts
    2. Myth #2; GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena
    3. Myth #3; GAAP should tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users
  2. Eleven underlying assumptions of GAAP which provide insights into its uses and limitations:
    1. ownership of, that is, title to, tangible assets is the basis of value and the means of creating income
      1. ignores the value of intangible assets, such as lack of debt or ability to create new debt, advantageous debt terms, price at which new equity can be raised, etc.
      2. some other intangibles:
        1. long-term, favorable (or unfavorable) contracts with key employees, customers and vendors
        2. trade names and patents
        3. distribution channels, such as dealer organizations
        4. manufacturing know-how
        5. licenses to do business
        6. tax-loss carry-backs (worth cash) and tax-loss carry-forwards
      3. GAAP becomes increasingly less descriptive when intangibles play a larger role in creating value and income
        1. GAAP provides good benchmarks to value the output of a steel mill, for example
        2. GAAP does not provide good bench marks for valuing the worth of a medical degree
    2. corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern
      1. as a practical matter, few assets of a going concern have value that is independent of the going concern
      2. independent values exist only in asset-conversion
      3. passivity and liquidity are highly interrelated; more liquidity means less responsibility in administering the asset
    3. changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members
      1. GAAP is an establishment tool and its basic purpose is to aid, not to fight or alter, an existing economic system
      2. changes should be expected to be evolutionary, not revolutionary or radical
    4. a puritan work ethic is desirable; hence achievement through going-concern operations are far more desirable than achievements through asset conversions– mergers and acquisitions, reorganizations or refinancings
      1. profit should be created from going-concern operations, not capital appreciation through asset arbitrage
    5. the medium is the message
      1. immediate stock market impact is what financial statements are directed to
    6. precise definitions are a desirable goal
      1. as much as possible, items should be defined as expense or income, liability or proprietorship
      2. except for insurance-company accounting, no recognition that many items (deferred income taxes, unexpired subscriptions, low-interest rate mortgage loans, etc.) have elements of both expense and income, or liability and proprietorship
    7. GAAP is designed primarily to protect the cash buyer of securities
      1. great bulk of cash buyers of corporate securities are lending institutions– banks, insurance companies, pension trusts and finance companies
      2. GAAP tends to explain “how bad things are if you give up your cash for this security”
      3. GAAP is less suited to explain how a holder of equity securities will fare when asked to give them up for cash or other securities, such as in an acquisition or merger
    8. security holders tend to be monolithic: all have the same interests
      1. GAAP assumes all stockholders are interested in the price of the stock they own
    9. per-share market prices are per se important and are the single most significant indicator of the value of entire businesses
    10. in classifying assets or liabilities, physical substance and legal substance are deemed to be more important than economic substance
      1. often non-current, fixed assets are highly liquid due to their being subject to asset-conversation activities
      2. similarly, many current assets are locked up as part of the operation of the going-concern and are not liquid or marketable
    11. there is a basic identity of interests between a company and its various stockholder groups
      1. much more realistic to consider the relationships between company and stockholders and stockholders vs. stockholders as combinations of communities of interest and conflicts of interest
  3. Myths about the shortcomings of the corporate audit function and the ethical standards of the US independent auditing profession
    1. most speculative bubbles have been in industries or issues where GAAP is either nonexistent or of little significance in appraising a business or stock

Chapter 9, Tax Shelter (TS), Other People’s Money (OPM), Accounting Fudge Factor (AFF) and Something Off the Top (SOTT)

  1. Tax shelters
    1. people try to avoid maximum rates
    2. people try to avoid being unable to control the timing of a tax liability
    3. people try to avoid transactions that produce a taxable event but not the cash to pay for it
  2. Other People’s Money
    1. OPM is different in different situations
      1. banks, it is depositors’ money
      2. AmEx, it is paid but not cashed traveler’s checks
      3. insurance company, it is premiums paid
    2. OPM can be used to enrich an opportunistic promoter at little to no cash cost to himself
    3. OPM is dangerous for common-stock investors
      1. hard to predict the short- to intermediate-term price activity
      2. danger of loss where there is a lack of positive cash-carry (cash income on investment exceeds cash interest costs of loan)
  3. Something Off The Top
    1. insiders view outsiders SOTT as having a free ride; enjoying the profits of a company without doing the work
    2. insiders themselves enjoy SOTT through special information access, nice offices, special opportunities through business relationships and contacts, opportunities to buy cheap stock and PPM (power, prestige, money)
    3. control can often be a negative in the event of a company being “sick”; in this case, being an outsider is SOTT
    4. a general rule for public investors is to avoid companies whose mgmts have general disdain for outsiders and try to claim SOTT at their expense
  4. Some preliminaries on the Accounting Fudge Factor (AFF)
    1. there is no “right” way to account for things
    2. are you a senior lender, a common stockholder or the president of the company, etc?
    3. are you interested in cash returns, the build-up of intrinsic value, the price of the stock or some combination of the three?

Chapter 10, Securities Analysis and Securities Markets

  1. Companies and securities can only be analyzed in context; what is good or bad in one context becomes bad or good in another
  2. Variables that can not be quantified as good or bad:
    1. profit margins
    2. size
    3. liberal accounting policies
    4. low net asset value
    5. Wall Street sponsorship
    6. the trading assumption versus the investment assumption
    7. convertible securities
    8. limitations of comparative analysis
  3. Reasons for acquiring and holding securities
    1. aggressive mgmts might fully utilize liquidity, thus creating a weak financial position
    2. high book value relative to market price when price-earnings ratios are high results in low return on investment
    3. companies with high profit margins, high stock prices and low book values attract competition
    4. companies that survive and prosper in highly cyclical, unprotected industries tend to be run by able mgmts
  4. Profit margins
    1. low profit margins can be a strong reason for purchasing a security if it is believed the margins will improve; small improvements in low margin situations can result in big, leveraged returns
    2. companies with consistently high profit margins tend to be popular and thus over-priced
    3. it often happens that companies with consistently high profit margins suddenly lose them overnight
  5. Size
    1. small companies should be chosen because of the appreciation potential inherent in their prospects for growing into giant businesses
    2. many small and medium sized companies are well financed and effective competitors, meaning they are high quality issuers even if not recognized as such
    3. large firms are best selected by investors with no ability or time to get to know their investments better
    4. in general, the smaller the business, the riskier, however, there are times when high prices can make large businesses riskier on a relative basis
  6. Liberal accounting policies
    1. a firm can use liberal accounting policies to gain market sponsorship through excitement about its strong earnings profile; this market sponsorship can be used to attract financing at extremely generous rates, improving the firm’s financial position
    2. if a stock goes up far enough and its management is astute, it can use the “Chinese dollar”, or puffed value, to buy economic value elsewhere at a discount
    3. The standard of investment behavior for passivists as well as activists should be, “Worry about the investments you made, that you shouldn’t have,” not, “Worry about the investments you should’ve made, but didn’t”
  7. Advantages of a low net asset value
    1. a company with a lower NAV might have a higher ROI
    2. all assets come with encumbrances; sometimes having a lower NAV relative to a competitor with higher NAV can result in greater ROI because the higher NAV requires more maintenance and other costs to keep it current, even when not actively productive
  8. Wall Street sponsorship
    1. “sponsored security” is an issue that is recommended and/or purchased by people in the financial community who are able to lure or influence others to acquire that security
    2. important for those interested in immediate performance or timing or in owning a highly marketable, actively traded security
    3. buying poorly sponsored or unsponsored equity securities has its advantages for long term investors because this is typically where bargains are found
  9. The trading assumptions versus the investment assumptions
    1. Much advice about how to invest is given from the perspective that the market knows more than the individual investor, and thus should be heeded accordingly
  10. Convertible securities
    1. issuers of convertibles are frequently second-rank companies who include convertibility to “sweeten the deal”
  11. Limitations on comparative analysis
    1. the goal is not completeness, but “good enough”; time and knowledge are at a premium
    2. “good enough” is the standard for measuring market and business performance; no one can be best all the time or own all the resources in the world

Chapter 11, Finance and Business

  1. Heavy Debt Load
    1. high debt can be viewed as a reason to purchase a stock, especially in a bull market, because many equate it to aggressive mgmt
    2. another reason high debt can be an asset is if the debt was acquired at attractive terms and competitor firms are not able to replicate such financing
  2. Large cash positions
    1. can be a sign of unattractiveness when:
      1. entrenched, non-raidable mgmts refuse to make productive use of funds
      2. where mgmt refuses to use funds to undertake necessary expenditures
    2. watch out for companies that appear strong financially but operationally are weak because they have not invested properly in their businesses
  3. Diversification versus concentration
    1. some enterprises excel with a singular focus
    2. others benefit from diversification
    3. the jury is out
  4. Management incentives
    1. management expenses and salaries are paid before all other securities
    2. management looting is generally not a problem in larger firms, but it is widespread enough that no security holder should assume there is a community of interest between mgmt and security holders
  5. Advantages of highly cyclical companies in competitive industries
    1. the adversity and challenge of these industries tend to attract highly talented mgmt
    2. they also tend to be well financed and relatively liquid because they can’t afford not to be
  6. Going public and going private
    1. What a business is worth as a private enterprise is different from what it is worth as a public enterprise
    2. A private company can go public by selling its own equities, or it can sell out for cash to a company that is already public
    3. Many times a public company is worth far more private than public so it will go private by purchasing up shares for cash
      1. a company repurchasing stock is, in effect, going private when it does so
  7. Who runs most companies?
    1. Myth is that they’re run by their directors; day-to-day reality is they are run by their mgmt
  8. Consolidated versus consolidating financial statements
    1. Sometimes, due to cross-ownership of securities held within a senior organization, the common equity of a child company can take a “de facto” status as a senior security within the parent organization
  9. Negative values in owning assets
    1. “everything’s got a price”
    2. “I wouldn’t own that asset if you gave it to me”
    3. Because ownership of most assets entails obligations and expense, the second statement is typically truer than the first

Chapter 12, Net Asset Values

  1. The usefulness of book value in security analysis
    1. book value is an accounting number and it is limited in usefulness as any accounting number is
    2. by itself it means little; gains significance relative to other figures and information
    3. quantitative measure of assets; tells us “how much”
  2. Book value as one measure of resources
    1. the amount of resources a company has to create future earnings is a good indicator of future earnings power; book value measures available resources
    2. corporate buyers tend to focus on book value as an indicator of how they can redeploy newly acquired resources
    3. important in calculating ROI and ROE
  3. Book value as one measure of potential liquidity
    1. opportunities to create tax carry-backs can occur when a common stock is selling at a steep discount from brick-and-mortar book value and the business has been paying high tax rates
    2. useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records
    3. IRS can end up providing a substantial amount of the cash needed to finance the acquisition
  4. Book value analysis as a competitive edge
    1. most stock traders focus on short-term earnings, which is reflected in market prices
    2. focusing on large high-quality asset values as an indicator of good future earnings could give an investor an edge as these will not be reflected in high market prices
    3. changes in earnings and P/E ratios can be sudden and violent; changes in book value, however, tend to be gradual
  5. Limitations of book value in security analyses
    1. does not, in and of itself, measure the quality of a company’s assets
      1. high-quality means approaching being down free and clear of encumbrances
      2. high-quality means the business has a mix of assets and liabilities that appear likely to produce high levels of operating earnings and cash flows
      3. high-quality means assets tend to be salable at a price that can be estimated accurately

Chapter 13, Earnings

  1. Wealth or earnings?
    1. Generation of reported income is one way to create wealth
      1. another is creating unrealized appreciation
      2. another is realizing the appreciation that has been created
    2. Reported income generation is the least tax sheltered way to grow wealth; creates incentive for asset-conversion
    3. Private company mgmt tends to minimize reported income to minimize tax burden; public company mgmt tends to maximize to enjoy higher stock price
      1. allows investor to realize gains through selling and borrowing
      2. allows the company to issue stock for cash or to acquire other companies
  2. The long-term earnings record
    1. In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record
    2. The major component of NAV for most publicly owned businesses is retained earnings
    3. Earnings record is extremely important for a strict going-concern analysis
    4. Judging the quality of an issuer is another situation where a strong long-term earnings record is important to the analysis
  3. “Parsing” the income account
    1. The static-equilibrium approach
      1. looks at current earnings and the earnings record as principal factors in market price determination
      2. market prices within an industry tend toward equilibrium– a stock out of equilibrium could be a reason for buying or selling
      3. important in i-banking world, where new issues are commonly priced at lower than typical multiples as a marketing tool
    2. The dynamic-equilibrium model
      1. uses past and current record of current earnings as a base for estimating future earnings
      2. projected increase is then used for predicting a future stock price
    3. Various definitions of earnings
      1. what accountants using GAAP report them as
      2. what accountants using GAAP report them as, as measured by overall performance, including extraordinary items and discontinued operations
      3. the increase in value of a business (incl stockholder distributions) from one period to the next; ie, changes in NAV
      4. the increase in the ability to make stockholder distributions over and above actual stockholder distributions without reducing actual invested capital
      5. the increase in the ability to make payments to all security holders, not just equity holders, during a period
      6. the increase in ability to improve future sales, accounting profits and/or cash flow during a period
    4. use caution when an expanding business’ earnings are not “real” because they can not finance their own growth without being acquired, ex, Parliament brand cigarettes from small private company Benson and Hedges
    5. may make sense to stress “earning power” (wealth creation) versus “earnings” (reported accounting earnings)

Chapter 14, Roles of Cash Dividends in Securities Analysis and Portfolio Management

  1. The three conventional theories
    1. John Burr Williams
      1. common stock is worth the sum of all the dividends expected to be paid out on it in the future, each discounted to its present worth
      2. criticism: only apply in a tax-free world where the reason for owning stocks is to receive dividends and the reason for all corp activities was to pay dividends
      3. instead, more realistic to say that common stock held by non-control stockholders is worth the sum of all the net after-tax cash expected to be realizable in the future from ownership of the common stock, with such net cash coming in the form of cash disbursements from within the company (dividends, liquidations) or from without (stock purchasers, lenders accepting stock on margin)
    2. Modigliani and Miller
      1. as long as mgmt is thought to be working in the best interests of the shareholder, retained earnings should be regarded as equivalent to a fully subscribed, preemptive issue of common stock, and therefore that dividend pay-out is not material in the valuations of a common stock
      2. criticism: no evidence that mgmts share a “community of interest” with stockholders
      3. mgmt, if they are responsive to stockholders, tend to focus on the interests of holders that will bring the best benefits to mgmt
    3. Graham and Dodd
      1. in the vast majority of companies, higher common-stock prices will prevail when earnings are paid out in dividends rather than retained in a business
      2. criticism: emphasis should be on which stock — low dividend payer or high dividend payer — is more attractive to which type of investor
  2. Cash dividends as a factor in market performance
    1. ceteris paribus, a low dividend payer is better for an investor seeking market appreciation rather than cash-carry
    2. lower dividend companies tend to sell at lower prices, thus they tend to be more attractive buys
    3. a company whose common stock is available at a lower price will have more room to increase its dividend; dividend increase record is important for some in valuing stocks
    4. lower dividends translates to higher retained earnings and thus improved financial position over time
    5. countervailing argument: high-dividend payers tend to be better buys because a high payout ratio means mgmt is more attuned to the desires of most outside stockholders
    6. stockholders can be hurt by companies paying out high dividends long after it is wise for them to do so
    7. Graham and Dodd view is valid in the short-run but seems to make less sense in the long-run
  3. The placebo effect of cash dividends
    1. dividends increase in importance for securities holders insofar as they lack confidence in their outlook or mgmt or in the reliability of disclosures
    2. dividends are a hedge against being wrong
  4. Cash dividends and portfolio management
    1. Dividends increase in importance with the shareholder’s need for immediate cash income from his portfolio
    2. dividends become a negative factor when the shareholder wants a tax shelter or has no need for income and has confidence mgmt will successfully reinvest retained earnings
    3. securities with a high cash return can be attractive due to positive cash-carry
  5. Cash dividends and legal lists
    1. cash dividend income is a legal or quasi-legal necessity for many securities holders
  6. Cash dividends and bailouts
    1. the ability to convert assets to cash is a key consideration for many buyers for control purposes; always key for outside investors
    2. assuming an investor has no control over a company whose common stock he has invested in, eventually he will want the opportunity to convert into cash
  7. The goals of security holders
    1. most owners of senior securities are interested solely in cash income
    2. in contrast, some equity holders can be interested in cash return (dividends or cash sale of shares) but many are interested in earnings return

Chapter 15, Shareholder Distributions, Primarily from the Company Point of View

  1. Cash dividends or retained earnings
    1. “proper” dividend payout policy should be made from the point of view of the corporation, not the stockholder
    2. dividend payouts are a residual use of corporate cash and company requirements for cash in other areas have primacy
    3. dividend policy should be dictated by company needs for funds for expansion as well as for margin of safety
    4. companies should retain earnings whenever they have profitable ways to deploy it– this is not determined by the price of their stock as proclaimed by the stock market
    5. high dividends can be used by mgmt to create a higher stock price and thus protect the mgmt from raids
  2. Distributions of assets other than cash
    1. can create a taxable event with no cash to pay it
  3. Liquidation
    1. any payment by a corporation to its shareholders is a form of liquidation
    2. in truth, there is no such thing as liquidation in any meaningful sense, but rather asset-conversion
  4. Stock repurchases
    1. receipts of cash are taxed on a capital-gains rate only
    2. benefits:
      1. corporation benefits because cash requirements on future dividends are reduced
      2. EPS, BVS and corp reality value per share may be enhanced
      3. can promote strong stock market price, thus increasing the companies future financial position and financing opportunities
    3. disadvantages:
      1. if buy-ins are of massive size, investors may be forced out of the company at a price much lower than corp reality, even if at a substantial premium to market prices
      2. possible conflicts with insiders who might want to purchase shares, appearance of payoffs to insiders who want to sell

Chapter 16, Losses and Loss Companies

  1. Quality considerations and tax-loss companies
    1. an organization suffering economic losses can be attractive from the POV of asset-conversion acquisitions if:
      1. the resources employed by the company can be put to another use so losses are stemmed
      2. the business lacks overwhelming amounts of indebtedness
      3. it has available to it tax benefits growing out of the former losses
  2. On accounting and income
    1. tax benefits, for accounting purposes, are treated as extraordinary items
    2. however, these benefits have very real cash consequences and can generate substantial future earnings when reinvested, regardless of how they are accounted for
  3. Be wary of acquiring equity securities of the encumbered firm
    1. the danger in investing in loss corporations is that they have become so encumbered that there is no practical way to invest safely and profitably
    2. “big-bath” write-downs should be viewed as nonrecurring from the standpoint of judging the stewardship of the mgmt
  4. Commercial banks’ portfolio losses
    1. principal earnings assets of banks are investments in loans to customers and investments in securities, notably UST and munis
    2. when interest rates rise, the banks’ loan book falls in value, so they purposefully take losses to reinvest in higher yielding securities
  5. The “turned the corner” theory
    1. many times people will invest in small, losing companies with no record of profitability with the belief that when they “turn the corner” the market will substantially appreciate their new growth records
    2. risky
      1. hard to predict the future of uncertain businesses
      2. new issues normally not priced on bargain bases relative to corporate reality
    3. these securities rarely prove attractive from the FIA

Chapter 17, A Short Primer on Asset-Conversion Investing: Prearbitrage and Postarbitrage

  1. prices paid for common stocks for investment purposes are different from prices paid for control of businesses
  2. Four types of “do-able” asset-conversion activities that might be spotted with the FIA
    1. more aggressive employment of existing assets
    2. merger and acquisition activities
    3. corporate contests for control
      1. incorporated and domiciled in states where there are no strong anti-takeover statutes
      2. share ownership is widespread or blocks are locked up in private transactions
      3. possible low will of mgmt to resist a takeover
      4. absence of impediments to takeover, such as being in a regulated industry
      5. no antitrust problems
      6. there do not appear to be important people or institutions, such as customers, employees or suppliers, who could harm the takeover target by terminating relationships
    4. going private
  3. Postarbitrage
    1. occur after an asset-conversion event when securities owned by public shareholders remain outstanding
    2. sometimes when an offer to acquire securities is announced and less than all the shares tendered are accepted, arbitragers tend to dispose of masses of stock they have accumulated shortly afterward, depressing market prices
    3. important to avoid mgmts that have a predatory predilection
    4. post-arbitrage securities tend to be relatively unmarketable or not marketable at all
    5. one important rule of thumb: acquire shares at prices two thirds or less than control shareholders paid in the recent past to obtain control

 

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