One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Marty Whitman.
Whitman is the Chairman and Founder of Third Avenue. He’s recognized as a legend in the world of value investing and has proven for more than 50 years that active, opportunistic investors can find under-priced securities in companies with strong balance sheets. He’s also been a strong critic of GAAP earnings, citing the following in Kiplinger’s Personal Finance Magazine:
“Earnings are vastly overrated. Look at the title of my new book, Value Investing: A Balanced Approach (John Wiley & Sons). No smart businessman treats one accounting number as more important than another. They are all part of the whole. The goal of any business person is to create wealth, and except on Wall Street, profits are viewed as the least desirable way to create wealth because of the income-tax disadvantage. It’s a lot easier to look at the quantity and quality of resources a company has than to forecast its earnings. If you have good management, it will convert those resources into something of value.”
One of the best resources for investors are the Third Avenue Shareholder Letters, and one of the best letters ever written was Whitman’s 2012 letter in which he discussed the difference between traditional value investing and Fundamental Finance, which includes value investing. It’s a must read for all investors.
Here’s an excerpt from that letter:
Dear Fellow Shareholders:
The Third Avenue Management (“Third Avenue”) mode of operation is to emphasize Fundamental Finance (“FF”), rather that trading strategies. FF encompasses Value Investing, Control Investing, Distress Investing, Credit Analysis and First and Second Stage Venture Capital Investing. Third Avenue is, of course, primarily a Value Investor that is a passive, non-control investor.
FF approaches matters quite differently than do short run traders. In FF in 2012, the emphasis is on credit worthiness, rather than earnings or cash flows. In FF, managements are appraised not only as operators, but also as investors and financiers; as Value Investors, the bulk of Third Avenue efforts are directed toward investing in equities of financially strong companies which, over the long term, have good prospects to grow readily ascertainable Net Asset Values (“NAVs”); and also in FF, it becomes important to understand the motivations and practices of activists.
As such, FF tends to be quite different than activities revolving around trading, or academic finance as embedded in Modern Capital Theory (“MCT”). Also, as an FF disciple, I reject a number of commonly held beliefs including the concept of “too big to fail”; the definition of corporate failure; the belief that credit-worthy entities, corporate or governmental, ever repay indebtedness in the aggregate; or the belief that a capital infusion into a private enterprise by a governmental agency is, ipso facto a “bailout” rather than an “investment”.
It seems to me that almost all other approaches to investing and academic finance ranging from Principles of Corporate Finance by Brealey and Myers to Security Analysis Principles and Technique by Graham, Dodd and Cottle (“G & D”) to tracts on trading techniques focus on forecasting and explaining short-run market prices, especially on prices at which securities are traded in markets populated by Outside Passive Minority Investors (“OPMIs”). In sharp contrast, FF focuses strictly on explaining and understanding commercial enterprises and the securities they issue.
To me, short run market prices in OPMI markets are “random walks” except for the special cases of “sudden death securities”, such as options, warrants, certain convertibles and risk arbitrage situations where there will be relatively determinant workouts in relatively determinant periods of time. As a consequence of the 2008 economic meltdown an FF approach to investing became more relevant, and MCT and G & D approaches seem to have become less relevant.
A contrast in approaches between academic finance and FF is contained in the introduction to Brealy and Myers Principles of Corporate Finance (McGraw Hill 1991) a leading finance text, where the authors state “there are no ironclad prerequisites for reading this book except Algebra and the English language. An elementary knowledge of accounting, statistics and macroeconomics is helpful, however.”
To understand FF, however, the market participant ought to strive to become knowledgeable in several fields – knowledgeable enough to be an informed client. FF areas where knowledge is a prerequisite include the following:
- Securities Law and Regulations
- Financial Accounting
- Corporate Law with some emphasis on Delaware Law
- Income Tax
Other disciplines that might come into play depending on the particular situation being analyzed are Bankruptcy Law, Insurance Law and Regulation, Banking Law and Regulation, Environmental Law, etc. To others, the default position embodies the MCT view that markets are efficient, to wit, the price is right. In FF, in contrast, most prices are quite wrong most of the time.
In FF, control issues and changes in control are a major consideration. Control issues are pretty much ignored by MCT and G & D. Control common stocks and passively owned common stocks are the same in form but control common stocks are, in fact, a vastly different commodity than non-control common stock, certainly priced very differently in their respective markets. Control issues are also highly important in restructuring troubled issuers. It appears as if subsequent to the 2008-2009 economic meltdown, an increased percentage of changes of control have occurred through recapitalization, asset sales and capital infusions involving troubled publicly-owned companies, rather than has occurred through acquiring common stocks or using the proxy machinery to effect changes of control of healthy companies.
The conventional thinking seems to be that one has to take huge risks to obtain huge rewards. I demur. Rather, the royal road to riches is not to take investment risks, but, rather, to lay off the investment risks on someone else. Great fortunes have been built by those who successfully laid off investment risk on others. These success stories include the following people:
- Corporate Executives
- Hedge Fund Operators
- Plaintiffs’ Attorneys
- Bankruptcy Attorneys and Investment Bankers
- Securities Brokers
- Venture Capitalists
The best – but far from the only – way for OPMIs to lay off investment risk is to acquire securities that are high quality and have good prospects for growing NAV over the long term. The elements that go into investing in such common stocks encompass the following:
- The issuer has to enjoy a super strong financial position.
- The common stock has to be available at, at least, a 20% discount from readily ascertainable NAV.
- The company has to provide comprehensive disclosures, including complete audits, and also be listed or traded in markets in jurisdictions that provide strong investor protections. (The U.S., Canada and Hong Kong being examples).
- After thorough analysis the prospects appear good that, over the next three to seven years, the company will be able to increase NAV by not less than 10% compounded annually after adding back dividends.
These are certain shortcomings to this approach. A strong financial position, especially in the 2012 low interest rate environment, means the OPMI is dealing with managements willing to sacrifice Return on Equity (“ROE”) and Return on Assets (“ROA”) in exchange for the insurance against adversity provided by a strong financial position; and the opportunism for companies that arise out of a strong