Modern Security Analysis E-Book

Martin J. Whitman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 823

Veröffentlichungsjahr: 2013

Beschreibung

A legendary value investor on security analysis for a modern era This book outlines Whitman's approach to business and security analysis that departs from most conventional security analysts. This approach has more in common with corporate finance than it does with the conventional approach. The key factors in appraising a company and its securities: 1) Credit worthiness, 2) Flows--both cash and earnings, 3) Long-term outlook, 4) Salable assets which can be disposed of without compromising the going concern, dynamics, 5) Resource conversions such as changes in control, mergers and acquisitions, going private, and major changes in assets or in liabilities, and 6) Access to capital. * Offers the security analysis value approach Martin Whitman has used successfully since 1986 * Details Whitman's unconventional approach to security analysis and offers information on the six key factors for appraising a company * Contains the three most overemphasized factors used in conventional securities investing Written by Martin J. Whitman and Fernando Diz, Modern Security Analysis meets the challenge of today's marketplace by taking into account changes to regulation, market structures, instruments, and the speed and volume of trading.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Acknowledgments

Introduction

OUR FOCUS

CREDITWORTHINESS

THE APPRAISAL OF MANAGEMENTS

ACCESS TO CAPITAL MARKETS AND WEALTH CREATION

THE IMPORTANCE OF CONTROL

THE AVOIDANCE OF INVESTMENT RISK

MARKET EFFICIENCY?

DEBUNKING MYTHS

YOU NEED A LOT MORE THAN KNOWLEDGE OF ALGEBRA AND THE ENGLISH LANGUAGE TO UNDERSTAND OUR APPROACH.

OTHER TOPICS WE COVER IN THE BOOK

Part One: The Foundations of Modern Business and Security Analysis

Chapter 1: The Scope of Fundamental Finance, Investing, and the Investor Landscape

INVESTING VERSUS SPECULATING

THE OPMI DEFINED

ACTIVISTS

SUMMARY

Chapter 2: A Short Introduction to the Going Concern and Resource Conversion Views of Businesses

METHODS OF WEALTH CREATION

THE PURE GOING CONCERN VIEW

THE RESOURCE CONVERSION VIEW

SUMMARY

Chapter 3: Substantive Consolidation and Structural Subordination

SUBSTANTIVE CONSOLIDATION NOT OF PRIME IMPORTANCE

THE ACCOUNTING FOR STOCK OPTIONS CONTROVERSY IN LIGHT OF THE SUBSTANTIVE CONSOLIDATION DOCTRINE

STRUCTURAL SUBORDINATION NOT A SIGNIFICANT FACTOR

LACK OF PROGRESS IN EUROZONE CRISIS RESOLUTION: THE FAILURE TO USE SUBSTANTIVE CONSOLIDATION

SUMMARY

Chapter 4: The Substantive Characteristics of Securities

TYPES OF SECURITIES FOR ANALYTIC PURPOSES

CONTROL VERSUS NON-CONTROL SECURITIES

CONTROL AND NON-CONTROL PRICING AND ARBITRAGE

TERMS OF SECURITIES AS OPTIONS

WHAT A SECURITY IS DEPENDS ON WHERE YOU SIT

SUMMARY

Chapter 5: Primacy of the Income Account or Wealth Creation? What Are Earnings, Anyway?

WEALTH OR EARNINGS?

INFLUENCE OF REPORTED EARNINGS ON COMMON STOCK PRICES

THE LONG-TERM EARNINGS RECORD

PARSING THE INCOME ACCOUNT

SUMMARY

Chapter 6: Net Asset Value: The Static and Dynamic Views

THE GRAHAM AND DODD VIEW ON NAV

THE FINANCIAL ACCOUNTING VIEW ON NAV

OUR VIEW ON NAV

THE USEFULNESS OF NAV IN SECURITY ANALYSIS

THE IMPORTANCE OF NAV DYNAMICS

NAV AS ONE MEASURE OF RESOURCES

NAV AS ONE MEASURE OF POTENTIAL LIQUIDITY

LIMITATIONS OF NAV IN SECURITY ANALYSES

LARGE PREMIUMS OVER BOOK VALUE USUALLY MEAN HIGH P/E RATIOS: IT DEPENDS ON ROE

NET NETS REDEFINED

OPMI INVESTING IN COMPANIES WITH GROWING NAVS

SUMMARY

Chapter 7: Creditworthiness

CREDITWORTHINESS FROM THE BORROWING ENTITY POINT OF VIEW

CAPITAL STRUCTURE

CAPITAL STRUCTURE FROM THE CORPORATE PERSPECTIVE

FACTORS AFFECTING CAPITAL STRUCTURE

CONSERVATIVE CAPITAL STRUCTURES

SUMMARY

Chapter 8: What Matters Is Investment Risk

THERE IS NO GENERAL RISK—ONLY SPECIFIC RISK

THE COMPONENTS OF INVESTMENT RISK

SUCCESSFUL PEOPLE AVOID INVESTMENT RISK

METHODS TO AVOID INVESTMENT RISK

SAFE AND CHEAP INVESTING AND MINIMIZING INVESTMENT RISK

SUMMARY

Chapter 9: Shareholder Distributions from the Company Point of View

CASH DIVIDENDS OR RETAINED EARNINGS

STOCK DIVIDENDS

STOCK REPURCHASES

DISTRIBUTION OF ASSETS OTHER THAN CASH

LIQUIDATION

SUMMARY

Chapter 10: Roles of Cash Dividends in Security Analysis and Portfolio Management

THE THREE CONVENTIONAL THEORIES

CASH DIVIDENDS AS A FACTOR IN MARKET PERFORMANCE

THE PLACEBO EFFECT OF CASH DIVIDENDS

CASH DIVIDENDS AND PORTFOLIO MANAGEMENT

CASH DIVIDENDS AND LEGAL LISTS

CASH DIVIDENDS AND BAILOUTS

THE GOALS OF SECURITIES HOLDERS

SUMMARY

Chapter 11: The Appraisal of Managements and Growth: GARP versus GADCP

NEW FRAMEWORK FOR THE APPRAISAL OF MANAGEMENTS

MANAGEMENTS ATTUNED TO OPMI INTERESTS

MANAGEMENTS AS RESOURCE CONVERTERS

TRADEOFFS

GROWTH: GARP VERSUS GADCP

GROWTH AT A REASONABLE PRICE (GARP)

GROWTH AT DIRT CHEAP PRICES (GADCP)

SUMMARY

Chapter 12: The Significance (or Lack of Significance) of Market Performance

MARKET PERFORMANCE AND THE CHARACTER OF A PORTFOLIO

MARKET PERFORMANCE OF PORTFOLIOS VERSUS INDIVIDUAL SECURITIES

OUTSIDERS, INSIDERS, AND MARKET PRICE

PROFESSIONAL MONEY MANAGERS AND BEATING THE MARKET

PERSPECTIVE ON BAILOUTS AND THE SIGNIFICANCE OF MARKET PERFORMANCE

SUMMARY

Chapter 13: How Much Diversification?

PORTFOLIO DIVERSIFICATION VERSUS SECURITIES CONCENTRATION

CORPORATE DIVERSIFICATION VERSUS CONCENTRATION

SUMMARY

Chapter 14: Toward a General Theory of Market Efficiency

THE DETERMINANTS OF MARKET EFFICIENCY

EXTERNAL FORCES INFLUENCING MARKETS EXPLAINED

GREAT ECONOMISTS CAN LEARN A LOT FROM VALUE INVESTORS

MARKETS WHERE EXTERNAL DISCIPLINES SEEM TO BE LACKING

MARKET EFFICIENCY AND FAIR PRICES IN TAKEOVERS

SUMMARY

Part Two: Putting It All Together: Safe and Cheap Investing versus Conventional Approaches

Chapter 15: Safe and Cheap Investing

THE SAFE AND CHEAP APPROACH

BENEFITS OF THE SAFE AND CHEAP APPROACH FOR THE OPMI

RESTRICTIONS AND DEMANDS OF THE SAFE AND CHEAP APPROACH

SUMMARY

Chapter 16: Graham and Dodd Placed in Context

THE OPMI DEFINED

THE OPMI PERSPECTIVE OF ANALYSIS

THE GOING CONCERN AND INVESTMENT COMPANY VIEWS OF BUSINESSES

PRIMACY OF THE INCOME ACCOUNT AND WEALTH CREATION

PRIMACY OF THE INCOME ACCOUNT, DIVIDENDS, AND CORPORATE USES OF CASH

PRIMACY OF THE INCOME ACCOUNT AND THE APPRAISAL OF MANAGEMENTS

PRIMACY OF THE INCOME ACCOUNT AND TOP-DOWN VERSUS BOTTOM-UP ANALYSIS

PRIMACY OF THE INCOME ACCOUNT AND DIVERSIFICATION

PRIMACY OF THE INCOME ACCOUNT AND GROWTH STOCKS

MARKET RISK VERSUS INVESTMENT RISK AND MARGIN OF SAFETY

THE IMPORTANCE OF MARKET PERFORMANCE

USES AND LIMITATIONS OF FINANCIAL ACCOUNTING

SUBSTANTIVE CONSOLIDATION

COMPENSATION OF PROMOTERS

DO STOCK MARKET PRICES REFLECT CORPORATE VALUES?

TRADE-OFFS

MODERN CAPITAL THEORY VERSUS GRAHAM AND DODD

SUMMARY

Chapter 17: Academic Finance: Modern Capital Theory

THE MCT POINT OF VIEW

EQUILIBRIUM PRICING IS UNIVERSALLY APPLICABLE

THE OUTSIDE PASSIVE MINORITY INVESTOR IS THE ONLY RELEVANT MARKET

DIVERSIFICATION IS A NECESSARY PROTECTION AGAINST UNSYSTEMATIC RISK

SYSTEMATIC RISK EXISTS

VALUE IS DETERMINED BY FORECASTS OF DISCOUNTED CASH FLOWS

COMPANIES ARE ANALYZED BASICALLY AS GOING CONCERNS; INVESTORS IN MARKETABLE SECURITIES ARE ANALYZED AS INVESTMENT COMPANIES

INVESTORS ARE MONOLITHIC: THEIR UNITARY GOAL IS RISK-ADJUSTED TOTAL RETURN, EARNED CONSISTENTLY

MARKET EFFICIENCY MEANS AN ABSENCE OF MARKET PARTICIPANTS WHO EARN EXCESS RETURNS CONSISTENTLY OR PERSISTENTLY

GENERAL LAWS ARE IMPORTANT

RISK IS DEFINED AS MARKET RISK

MACRO CONSIDERATIONS ARE IMPORTANT

CREDITOR CONTROL IS A NONISSUE

TRANSACTION COSTS ARE A NONISSUE

FREE MARKETS ARE BETTER THAN REGULATED MARKETS

THE OUTSIDE PASSIVE MINORITY INVESTOR MARKET IS BETTER INFORMED THAN ANY INDIVIDUAL INVESTOR

MARKETS ARE EFFICIENT OR AT LEAST TEND TOWARD AN INSTANTANEOUS EFFICIENCY

SUMMARY

Chapter 18: Broker-Dealer Research Departments and Conventional Money Managers

HOW RESEARCH DEPARTMENTS AND CONVENTIONAL MONEY MANAGERS THINK

PROBLEMS FACED BY RESEARCH DEPARTMENTS AND CONVENTIONAL MONEY MANAGERS

SUMMARY

Part Three: Real-World Considerations

Chapter 19: Uses and Limitations of Financial Accounting

THE CONVENTIONAL APPROACHES

FINANCIAL ACCOUNTING REPORTS AS OBJECTIVE BENCHMARKS

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AS DEFINING REALITY FOR CERTAIN SPECIFIC PURPOSES

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AS A ROAD MAP FOR DUE DILIGENCE AND LESS THOROUGH INVESTIGATIONS

SUMMARY

Chapter 20: Company Disclosures and Information: Following the Paper Trail in the United States

NARRATIVE DISCLOSURES IN THE UNITED STATES

THE DOCUMENTS AND HOW TO READ THEM

WHAT THE PAPER TRAIL DOES FOR THE OUTSIDE INVESTOR

WHAT THE PAPER TRAIL DOESN’T DO

HOW GOOD IS THE PAPER TRAIL?

SUMMARY

Chapter 21: Buying Securities in Bulk

METHODS FOR ACQUISITION OF COMMON STOCKS

ACQUISITION OF VOTING EQUITIES THROUGH EXCHANGES OF SECURITIES

ACQUISITION OF CONTROL WITHOUT ACQUIRING SECURITIES BY USING THE PROXY MACHINERY

SUMMARY

Part Four: Understanding Resource Conversion

Chapter 22: A Short Primer on Resource Conversion

LONG-TERM ARBITRAGE BETWEEN OPMI PRICES AND CONTROL VALUES

MORE AGGRESSIVE EMPLOYMENT OF EXISTING ASSETS

MERGER AND ACQUISITION ACTIVITY

CORPORATE CONTESTS FOR CONTROL

GOING PRIVATE AND LEVERAGED BUYOUTS

SUMMARY

Chapter 23: Restructuring Troubled Companies

THE FIVE BASIC TRUTHS OF DISTRESS INVESTING

REHABILITATION OF TROUBLED ENTITIES

SUMMARY

Chapter 24: The Role of Government in Reorganizations

BAILOUTS OR CAPITAL INFUSIONS?

TOO BIG TO FAIL IS A PHONY CONCEPT

THE GOVERNMENT AND PRIVATE SECTOR ARE IN PARTNERSHIP WHETHER THEY LIKE IT OR NOT

WALL STREET PROFESSIONALS AND CORPORATE EXECUTIVES ARE ALL IN THE BUSINESS OF CREATING MORAL HAZARDS

TAXPAYER BAILOUTS ARE A PHONY CONCEPT

A REVOLUTION IN CORPORATE REORGANIZATIONS AND LIQUIDATIONS MAY HAVE OCCURRED IN 2009 WITH THE CHAPTER 11 REORGANIZATIONS OF GENERAL MOTORS, CHRYSLER, AND CIT CORPORATION

STRICT REGULATION OF FINANCIAL INSTITUTIONS IS ABSOLUTELY NECESSARY

SUMMARY

Part Five: Active Investors Buy and Sell Common Stocks on an Advantageous Basis

Chapter 25: The Economics of Private Equity Leveraged Buyouts

THE 2005 ACQUISITION OF HERTZ GLOBAL HOLDINGS AND SUBSEQUENT EVENTS AS A PRIME EXAMPLE

SUPER-ATTRACTIVE ACCESS TO CAPITAL MARKETS

CASH PAYMENTS TO SPONSORS AND SPONSOR-CONTROLLED FUNDS

SPONSORS CONTROL OF HERTZ

SPONSORS ATTUNED TO THE NEEDS OF BANKERS AND THE WALL STREET UNDERWRITING COMMUNITY

QUESTIONS ABOUT LBOS

SUMMARY

Chapter 26: The Use of Creative Finance in a Corporate Takeover

THE CASE

THE POSTSCRIPT

INVESTMENT LESSONS

THE APPRAISAL OF MANAGEMENT

SPOTTING DOABLE DEALS

SUMMARY

Chapter 27: The Use of Creative Finance to Benefit Controlling Stockholders

THE PROBLEMS FACED IN THE SCHAEFER CORPORATION DEAL

THE BACKGROUND OF THE DEAL

DISCOUNT PURCHASES OF RESTRICTED CORPORATE STOCK

CORPORATION’S ACQUISITION OF BREWING

PROBLEMS AND WEALTH CREATION POTENTIALS FOR THE PARTIES IN INTEREST

SUMMARY

Glossary of Acronyms

About the Authors

Index

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Copyright © 2013 by Martin J. Whitman and Fernando Diz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Whitman, Martin J. Modern security analysis : understanding Wall Street fundamentals / Martin J. Whitman, Fernando Diz. pages cm. — (Wiley finance series) Includes index. ISBN 978-1-118-39004-7 (cloth); 978-1-118-60265-2 (ebk); 978-1-118-60301-7 (ebk); 978-1-118-60338-3 (ebk) 1. Investment analysis. I. Diz, Fernando, 1956–. II. Title. HG4529.W487 2013 332.63′2042—dc23

2013000737

To the Deans, Faculty, Staff, Students and Alumni of

The Whitman School of Management

at

Syracuse University

Acknowledgments

There are so many people who contributed to our knowledge, and to the specifics of this book, that it is impossible to acknowledge and thank all of them. We have singled out a few names but in doing so have no intent of shortchanging those contributors who we fail to mention.

At Syracuse University we are especially grateful for the help and advice given to us by Deans Mel Stith and Tom Foley; Professors Bill Walsh and Randy Elder; students in the Orange Value Fund program—all at the Whitman School of Management; University Trustees and alumni Dick Haydon, Steve Ballentine, Bernard Kossar, Mike Dritz, John Couri, Steve Barnes, Ken Goodman, and Jay Genzer.

At Third Avenue Management, we benefited much from advice rendered by David Barse, Tom Gandolfo, Vinny Dugan, and Hal Drachman. Bridget Wysong also was helpful. This book never would have seen the light of day without the herculean efforts of Beth Connor, executive assistant to Martin Whitman and Betty Ross, administrator of the Ballentine Investment Institute and the Orange Value Fund program coordinator at the Whitman School of Management.

One faculty member at Syracuse University Law School, GregoryGermain, and two at the Yale University School of Management, Stan Gartska andMartin Shubik, have to be singled out for their contributions. Others worthy of mention are Ronnie Chan, Bruce Flatt, Bruce Greenwald, and Arnie Jacobs.

It ought to be noted that both of us learned a lot from people we came to believe were bad guys and with whom we would never again invest. We won’t name names but rather just acknowledge that one tends to learn more from one’s mistakes than from one’s successes.

Also, our students at Syracuse, Yale, and Columbia contributed much to our knowledge. Quite possibly we learned more from them than they learned from us.

Finally, thanks to our families, especially Lois Whitman and Josefa Alvarez.

The errors and shortcomings of this book belong to us alone, not at all to the various contributors.

Martin J. Whitman Fernando Diz

Introduction

OUR FOCUS

This book is different from other books published about securities investing, securities trading, and academic finance as embedded in modern capital theory (MCT). It seems to us that all other books on investing andacademicfinance—ranging fromPrinciples of Corporate Finance (McGraw-Hill, 2002) by Brealey andMyers toSecurity Analysis: Principles and Technique (America Media International, reprinted 2003) by Graham, Dodd, and Cottle (G&D), and to tracts on trading techniques—focus on forecasting and explaining short-run market prices, especially prices at which securities are traded in markets populated by outside passive minority investors (OPMIs). This book, in sharp contrast, focuses strictly on explaining and understanding commercial enterprises and the securities they issue. For us, short-run market prices in OPMI markets are so-called 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 determinate workouts in relatively determinate periods of time.

It seems to us that our approach became more relevant as a consequence of the 2008–2009 meltdown, whereas MCT and G&D approaches became less relevant.

In this book the emphasis is on creditworthiness rather than earnings and cash flows, the appraisals of managements not only as operators but also as investors and financiers, and understanding the motivations and practices of activists.

CREDITWORTHINESS

Throughout the book we emphasize the importance of creditworthiness. Three elements go into the determination of creditworthiness for functional purposes:

1. Amount of debt

2. Terms of debt

3. How productive are the use of proceeds from incurring the debt

Of these, we argue that the third element is the most important.

Also, there are three tests of solvency, and most entities do not have to pass all three to be deemed solvent.

1. Does the fair value of the assets exceed the claims against those assets (a balance sheet test)?

2. Does the entity have the wherewithal to meet its obligations as they come due (an income account test)?

3. Does the entity have access to the capital markets to meet cash shortfalls (a liquidity test)?

THE APPRAISAL OF MANAGEMENTS

Unlike others who view managements solely as operators of businesses, we appraise managements in their competencies as operators, investors, and financiers. Recently we have been acquiring the common stock of Lai SunGarment, a reasonably fast-growing and reasonably well-financed company with assets (mostly real estate) in Hong Kong and Mainland China. The common stock at this writing is selling at about an 80 percent discount from net asset value (NAV) and less than two times reported earnings for theyear ended July 30, 2012. The one question we have about Lai Sun Garment management is as financiers. With the common stock priced the way it is, why isn’t the company either buying in its own common stock or the common stock of its 47 percent owned subsidiary, Lai Sun Development, whose common stock sells at a similar discount from NAV and a similar price-to-earnings (P/E) ratio? If a goal of the business is to grow NAV per share, at those prices it is hard to visualize a better use of surplus cash than buying in common stock rather than expanding the asset base or paying cash dividends.

In examining NAV, it is important to examine the dynamics of NAV rather than just NAV as a static concept. For almost all corporations, NAV will grow year by year almost continuously. The quality of NAV tends to be much more important than the quantity of NAV. Certain assets contained in book value reflect overhead unlikely to ever be recovered through earnings or cash flow. Those are the types of NAV common stocks we try to avoid. There are valuable lessons to be learned from G&D’s analysis of net nets.

Payments to shareholders in the form of either dividends or stock buybacks has to be a residual use of cash most of the time compared with using cash to expand corporate assets or reduce corporate liabilities. However, from a corporate point of view it sometimes makes sense to pay large and increasing dividends, because that can give the corporation better access to capital markets than would otherwise be the case. Also, managements might consider large dividends simply because they are desired by so much of the company’s OPMI constituency.

ACCESS TO CAPITAL MARKETS AND WEALTH CREATION

Another factor this book dwells on deeply that others seem to ignore is the importance for companies to have access to capital markets—both credit markets and equity markets. As the book points out, capital markets are notoriously capricious: sometimes not available at all (see the 2008 credit meltdown) and sometimes willing to give companies what might be characterized as “almost free money” (see the 1999 initial public offering [IPO] boom).

The goal of most corporations and most (but not all) OPMIs ought to be wealth creation, and it is important to note that there are four general ways to create wealth, not just the two seemingly cited by MCT and G&D. MCT and G&D believe in the primacy of the income account (i.e., creating wealth by flows, whether cash flows or earnings flows; earnings is defined as creating wealth while consuming cash). For us the four general ways of creating wealth—either corporate or individual—are:

1. Cash flow from operations

2. Earnings from operations

3. Resource conversion (i.e., massive asset redeployments, mergers and acquisitions, liability restructurings, changes of control, spinoffs, and liquidations)

4. Having attractive access to capital markets

It seems as if conventional security analysis puts overemphasis on four factors, which makes its approach much less useful in helping to understand a business. The four areas of overemphasis are:

1. Primacy of the income account (to the exclusion of balance sheet and financial position considerations)

2. Short-termism

3. Emphasis on top-down analysis and a consequent denigration of bottom-up analysis

4.Equilibrium pricing (i.e., the price at any moment of time represents an efficient market, and that price will change as the market digests new information)

G&D seem guilty on the first three accounts. MCT seems guilty on all four.

THE IMPORTANCE OF CONTROL

Unlike others, control issues and changes in control are a major consideration for us. Control issues are pretty much ignored by G&D and MCT. For us, control common stocks and passively owned common stocks are the same in form, but this book dwells heavily on why control common stocks are, in fact, a vastly different commodity than non-control common stocks, certainly priced very differently in their respective markets. Control issues are also highly important in restructuring troubled companies. We suspect that subsequent to the 2008–2009 economic meltdown, an increased percentage of changes of control has occurred through recapitalization, asset sales, and capital infusions involving troubled publicly owned companies than has occurred through acquiring common stocks or using the proxy machinery to effect changes of control of healthy companies.

The book contains three tales about the use of creative finance to create highly attractive returns for various participants:

1. The 2005 LBO of Hertz Global Holdings.

2. The Leasco acquisition of Reliance Insurance—getting control without putting up cash via the judicious use of an overpriced common stock.

3. Schaefer Brewing—letting control shareholders extract large amounts of cash from a company while the control shareholders stay in control.

THE AVOIDANCE OF INVESTMENT RISK

InSecurity Analysis1 G&D opine on the difference between investment and speculation. “An investment operation is one which upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” We agree wholeheartedly with G&D. In this book we attempt to convince the reader that a safe and cheap approach is an investment operation, not a speculation. The avoidance of investment risk is at the center of the safe and cheap approach.

There are three general measures of investment risk:

Quality of the issuer

Terms of the issue

Price of the issue

For us, diversification is only a surrogate—and usually a darned poor surrogate—for knowledge, control, and price consciousness.

Value investing as practiced by OPMIs is one aspect of fundamental finance (FF). FF covers the following areas:

Value investingDistress investingControl investingCredit analysisFirst and second stage venture capital investing

The most talented value investors seem to graduate into distress investing and control investing. Such graduates include Warren Buffett, Sam Zell, Carl Icahn, Bill Ackman, and David Einhorn.

We find that there are many, many value investors who are quite competent competitors. As far as we can tell, however, none seem to put as much emphasis on strong financial positions as we do in this book.

Safe and cheap investing is basically a buy-and-hold approach focused on the avoidance of investment risk that buys growth without having to pay for it. Security sales take place only when the security becomes grossly overpriced, when the analyst has made a mistake, when corporate conditions change, or for portfolio considerations.

MARKET EFFICIENCY?

To others, the default position embodies the MCT view that markets are efficient; to wit, the price is right. To us, in contrast, most prices are quite wrong most of the time.

The conventional thinking seems to be that one has to take huge risks to obtain huge rewards. In this book, we demur. Rather, for us the royal road to riches is not to take investment risks but rather to lay off the investment risks on someone else. Truly great fortunes have been built by those who have successfully laid off investment risk on others. These success stories include the following people:

Corporate executivesHedge fund operatorsPlaintiffs’ attorneysBankruptcy attorneysInvestment bankersSecurities brokersVenture capitalists

We further postulate that the best—but far from the only—way for OPMIs to lay off investment risk is to acquire securities that are both safe and cheap. The elements that go into safe and cheap investing in common stocks encompass the following:

The issuer has to enjoy a super strong financial position.The common stock has to be available at a minimum 20 percent discount from readily ascertainable net asset value (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 United States, 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 percent compounded annually after adding backdividends.

We do recognize certain shortcomings in our safe and cheap 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 arises out of a strong financial position. Also, the OPMI market seems efficient enough so that a large discount from NAV almost always indicates an absence of catalysts that could result in immediate market appreciation. For example, in our recommended list of securities in Chapter 6, none seems likely to undergo a change of control in the foreseeable future.

DEBUNKING MYTHS

The teachings in this book reject thoroughly a number of commonly held beliefs, including the concept of “too big to fail”; the definition of corporate failure; the belief that creditworthy 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.

For us, these beliefs are just plain wrong:

“Too big to fail” is meaningless. The standard has to be “too important not to be reorganized efficiently and expeditiously.” The reorganizations and/or capital infusions after 2008 into General Motors, Chrysler, CIT Group, Citigroup, and American International Group (AIG) are good examples of efficient and expeditious reorganizations of very important companies.We define corporate failure as a restructuring in which junior security holders are wiped out or almost wiped out. Chapter 11 reorganization does not define failure. Staying in business does not define success. After 2008, AIG and Citicorp both failed using our definitions of failure, though neither ever filed for Chapter 11 bankruptcy relief.In the aggregate, debt is almost never repaid by entities, which nevertheless remain creditworthy. Rather, debt is refinanced and expanded insofar as the entity—whether corporate or governmental—expands its borrowing capacity (i.e., becomes more creditworthy). Each of the companies whose common stocks are listed in Chapter 6 had greater borrowing capacity in 2012 than it had four or five years earlier. Be wary of putting debt limits on corporations or governments.

The difference between a bailout and an investment is that a bailout constitutes a capital infusion without any hope of a return, no matter how return is measured. If there are prospects of a return, as well as a return of principal, the capital infusion is an investment. The Troubled Asset Relief Program (TARP) instigated in 2008 to rescue U.S. banks was an investment by the government, not a bailout.

Great economists Keynes, Friedman, Hayek, and Modigliani and Miller probably could have learned a lot from value investors.

YOU NEED A LOT MORE THAN KNOWLEDGE OF ALGEBRA AND THE ENGLISH LANGUAGE TO UNDERSTAND OUR APPROACH.

A contrast in approaches between academic finance and us is contained in the introduction to Brealey and Myers’sPrinciples of CorporateFinance, a leading finance text, where the authors state that “there are no ironclad prerequisites for reading this book exceptAlgebra and the English language. An elementary knowledge of accounting, statistics and macroeconomics is helpful, however.” To get a lot out of this book, however, the reader ought to strive to become knowledgeable in several fields—knowledgeable enough to be an informed client. Areas where knowledge is prerequisite include:

Securities law and regulationsFinancial accountingCorporate law with some emphasis on Delaware lawIncome 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, and environmental law.

OTHER TOPICS WE COVER IN THE BOOK

Other views explained in depth in the book include the following:

In FF there is no substantive consolidation but plenty of structural subordination. In particular, the company is a stand-alone entity: It is not the management, and it is not the stockholders. Every constituency in an economic entity combines communities of interest and conflicts of interest in its relationships with other constituencies.Essentially, stock options are a stockholder problem, not a company problem.It is axiomatic that if an economic entity cannot be made creditworthy, sooner or later the entity has to be reorganized or liquidated. It seems to us that no one is really doing anything on the sovereign front to make Portugal, Ireland, Italy, Greece, and Spain creditworthy. For starters, at a minimum there is a need for efficiency rather than austerity.For most portfolios of performing loans, time corrects the error of having bought at too high a price.A fair price is one that would be arrived at between willing buyers and willing sellers, each with knowledge of the relevant facts and neither under any compulsion to act. Most going-private and leveraged buyout (LBO) transactions are characterized by a coerced seller and a willing buyer. However, OPMIs become willing sellers when offered premiums over market prices.

Instructors will find additional aids at www.wiley.com.

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1 Benjamin Graham, David L. Dodd, and Sidney Cottle. Security Analysis: Principles and Technique, fourth edition (New York: McGraw Hill, 1962) p. 47.

Part One

The Foundations of Modern Business and Security Analysis

CHAPTER 1

The Scope of Fundamental Finance, Investing, and the Investor Landscape

Investing versus Speculating

The OPMI Defined

Activists

Summary

Benjamin Graham and David Dodd (G&D) were prolific writers, publishing volumes in 1934, 1940, 1951 and 1962 and by Ben Graham alone in 1971. A principal problem with G&D is that almost everyone in finance talks about G&D, but very few seem to have actually read G&D.

Because so many have such a superficial understanding of G&D, their names have become synonymous with the term value investing. This, in turn, has led to some confusion about what it is that value investors do. Though we are influenced by G&D, our methods are basically different.

Value investing is one area of fundamental finance (FF). Value investing involves commitments in marketable securities by non-control outside passive minority investors (OPMIs).1 A thorough discussion of how we integrate the individual components of fundamental finance investing, discussed in the first part of this book, into our safe and cheap approach to value investing is contained in Chapter 15.

The other areas of fundamental finance involve the following:

Distress investing2Control investingCredit analysisFirst- and second-stage venture capital investing

Modern capital theory (MCT), like value investing, also focuses on investments by OPMIs. Unlike value investors, MCT focuses strictly on near-term changes in market prices and it is a top down approach rather than a bottom up approach. In a number of special cases the factors important in MCT are also important in value investing. MCT is discussed in Chapter 17.

INVESTING VERSUS SPECULATING

Since the five areas of fundamental finance involve different types of investing and value investing focuses on commitments in marketable securities by OPMIs, we need to be sure that the reader understands what we mean by the word investing.

In the first and subsequent editions ofSecurity Analysis,G&D devoted an entire chapter to the problem of clearly defining the meaning of the wordinvesting. Their goal was to come up with a definition that would serve as an objective benchmark that would allow people to distinguish between financial operations devoted to investing from those devoted to speculating. Although people seem to have a clear idea of what the differences between the two words are, G&D found that coming up with a precise definition of the terms ran into “perplexing” difficulties. We discuss a few of these difficulties or misconceptions that are still prevalent today later in this chapter.

The academic profession has not provided any guidance on this important matter, either. In fact, they have authoritatively contributed to the raging confusion that still exists today. For example, the prevailing view or conventional wisdom is that in order to achieve larger returns buying securities, one must undertake larger amounts of market risk. Of the many implicit mistakes in this view, one of them is the academic belief that all purchases of securities are investments. Nothing could be more misleading than this belief.

Why a Definition for Investing?

Why is it worthwhile to have precise definitions for investing and speculating? First, without a precise definition, we cannot distinguish between speculative and investment operations. On Wall Street, every speculator is called an investor. This is bad and very misleading semantics. But why should we distinguish between investing and speculating? This leads us to the second and, perhaps, more important reason. We do agree with G&D that the failure to distinguish between investment and speculative operations was in large part responsible for the wipeout or near wipeout of market participants during the 1928–1929 market crash. This failure continued to play an important role in more recent examples of wipeouts or near wipeouts of market participants (OPMIs generally) that occurred in 1974, 1987, 1989, 2000, and 2008–2009.

One of G&D’s often unrecognized and perhaps most important contribution to fundamental finance was the clear articulation of a precise definition for the concept of investing that we reproduce below:3

An investing operation is one, which upon thorough analysis that can be justified on both quantitative and qualitative grounds, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

The difficulties encountered by G&D in coming up with a precise definition were rooted in common misconceptions about what an investment is. The above definition is helpful in the clarification of many of these misconceptions, a few of which we discuss below.

The Type of Security Does Not Define What an Investment Is

There is nothing inherent to a financial instrument that makes it either an investment or a speculation. This misconception is alive and well today.

EXAMPLE

Treasury securities are widely viewed as investment vehicles. This view notwithstanding, purchasing a 2 percent 10-year Treasury note priced at par in 2012 seems a sure loser. No credit instrument ever achieves a market price much above its call price no matter how much interest rates go down, so it is hard to foresee meaningful capital appreciation for the Treasury note. If interest rates go up (seems a reasonable possibility from 2 percent), the market prices of the Treasury note will decline. Purchases of 2 percent 10-year Treasury notes carry a large amount of investment risk and thus can hardly be considered an investment operation. We discuss investment risk at length in Chapter 8.

Inherent to a security are only the rights that its holders have. Ownership of a security gives its owners one of two benefits:

1. Contractual rights to receive cash payments in the form of interest, return of principal, and premium. These rights in the United Sates cannot be taken away from holders unless the holder so consents or in a court of competent jurisdiction, usually a bankruptcy court.

2. Ownership rights, which may or may not provide for payments to owners of dividends or share repurchases that are not contractually required, except for the case of preferred stocks where cash service is required before cash is paid out to junior securities. These ownership rights can be outright or contingent as in the case of options and warrants.

Hybrid securities give their owners both benefits but at different times. Owners of convertible notes, convertible preferred stocks may have contractual rights to cash payments until they convert those rights into ownership rights.

We discuss these substantive characteristics of securities in Chapter 4.

The Method of Purchase and the Holding Time Horizon

Purchasing a common stock outright does not ispo facto make it an investment. Neither does buying the stock of a strongly financed company on margin make it a speculation. Similarly, the distinction between a permanent holding or temporary holding cannot be used to differentiate between investment and speculation. For example, riskless arbitrage involves the simultaneous purchase and sale of related securities, on margin, and for a short time period, but the transaction, properly executed, can be an investment operation, not a speculation. Riskless arbitrage is defined as a transaction that does not take any equity (or very little equity), guarantees safety of principal and a predetermined return in a fixed time period.

EXAMPLE

By September 2012 gold could be purchased in the cash market at $1,700 per ounce. Suppose a forward contract can be written to deliver physical gold in a year and get paid $1,800 per ounce. The cost of financing is 5 percent per year. An arbitrage transaction will involve:

Borrow say $170,000 for a year at 5 percent.Use the proceeds of the loan to buy 100 ounces of gold in the cash market.Simultaneously enter into a forward agreement to deliver 100 ounces of gold in a year and get paid $1,800/oz.In one year, regardless of what the price of gold in the cash and forward markets is, you will deliver 100 oz. of gold and get paid $180,000 for it; and you will repay principal and interest on your loan of $178,500 and pocket a riskless profit of $1,500.

The above operation does not have any investment risk, involves purchasing gold on a fully margined basis, for a short time period, and provides more than an adequate return on no equity.

For Income or for Total Return

One common misconception is that purchases of issues for income or cash return purposes are alsoipso factoinvestments. For market participants seeking satisfactory returns in mid-2012, it seems no longer possible to do so as a cash return investor. Interest rates are just too low. Rather the market participant has to focus on being a total return investor; that is, income plus capital gains. The futility of being a cash return investor is demonstrated by holding a 2 percent 10-year Treasury note priced at par. As we previously discussed, purchasing this instrument seems a sure loser. Thus, although it has become fashionable to talk about purchasing Treasury securities as a “return of capital” operation, the operation is fraught with investment risk and hardly compensates the purchaser with either an adequate cash or total return.

Investment Operation Rather than an Issue

As we have already discussed, investment character does not inhere in an issue per se. Price is frequently an essential element, so that a common stock or preferred stock or bond may have investment merit at one price but not at another. Along the same lines, an investment may be justified in a group of issues that could not be justified individually. Moreover, certain types of arbitrage and hedging commitments can also be considered investments. As we saw in the riskless arbitrage example, the element of safety in these types of operations is provided by the purchase/sale transaction.

Safety of Principal as the Avoidance of Investment Risk

For analytical purposes investment risk for a security has three components:

1. Quality of the issuer

2. Terms of the issue

3. Price of the issue

Investment must always consider theprice as well as thetermsof the security and thequality of the issuer: there is no investment issue in theabsolutesense; that is, implying that it remains an investment regardless of price. This is important to understand because semantics often obscure this fact. The purchase of a blue chip common stock is commonly considered as an investment at any price. Not so. An investment operation focuses on the appraisal and avoidance of investment risk as shown in the following example.

EXAMPLE

It is feasible today as a total return investor to buy into blue chip common stocks, which have the following characteristics and which in our opinion probably haven’t been as attractively priced as they are now since the mid-1970s:

Super-strong financial position (quality of issuer).Priced at a discount from net asset value of 25 percent or more (Wheelock and Company at a discount of about 50 percent) (price of the issue).Full comprehensive disclosures in English with audits by the Big Four (thorough analysis, based on both qualitative and quantitative grounds).Trading in markets where protections for OPMIs are strong (terms of the issue). Prospects seem good that over the next three to eight years net asset value (NAV) will grow by not less than 10 percent compounded annually after adding back dividends. If such growth is achieved, the investments seem very likely to be profitable because if not, the discounts from NAV would have widened to unconscionable levels.

THE OPMI DEFINED

Some participants in investment operations are OPMIs; others are activists having either control or elements of control over markets or corporate decision making. OPMIs are members of the public and are distinguishable from others in three respects:

1. Individually they have no control or influence over the businesses whose securities they hold or contemplate holding.

2. They do not have access to information other than that which is generally available to the public.

3. They are those whom the U.S. securities laws and regulations have been designed to protect.4

Throughout the book, we refer to them as OPMIs, as well as non-control and unaffiliated security holders. The key is that they are inactive in management and not connected with the company issuing securities in any way other than as security holders. OPMIs run the gamut from day traders to most institutional investors to value investors who do not seek elements of control over the companies in which they hold securities positions. The reason for using the term OPMI rather than investor is that the word investor is one of the most misused and misunderstood words on Wall Street and is often used to describe what G&D and we would refer to as speculators.

Non-control investors are also supposed to be the beneficiaries of various state laws and regulations, including blue sky statutes governing terms and conditions under which new issues may be offered;5 anti-takeover statutes; statutes aimed at controlling going-private transactions; more generalized common law and state statutory requirements covering the fiduciary obligations of those in control of corporations to unaffiliated common stockholders; and statutes defining appraisal remedies when stockholders dissent from force-out mergers or similar force-out transactions. OPMIs are additionally protected by rules promulgated by quasi-public bodies, particularly the Financial Institutions Regulatory Authority (FINRA).

ACTIVISTS

We regard as activists those participants in U.S. financial operations who have either control or elements of control or influence over businesses, who have or can obtain nonpublic information and whom federal securities regulations are intended to control rather than to protect. We believe the materials in this book are of interest to both activists and OPMIs.

SUMMARY

The concept of value investing that is often associated with Graham and Dodd is only one form of fundamental finance investing that involves making commitments in marketable securities by non-control, outside, passive minority investors or OPMIs. The other forms of fundamental finance investing are distress investing, control investing, credit analysis and first- and second-stage venture capital investing. Clearly understanding what investing is as opposed to speculation is a sine qua non for running fundamental finance investing operations, and the definition of investing is one of Graham and Dodd’s major contributions to the field of security analysis. We clearly define the concept of the OPMI but warn the reader that the concepts covered in this book can be used and are used by all those who run fundamental finance investing operations.

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1 Since most conventional approaches to investing, e.g., Graham and Dodd (discussed in Chapter 16), modern capital theory (discussed in Chapter 17), broker-dealerresearch departments and conventional money managers (discussed in Chapter 18), are centered on the OPMI, we provide a more detailed description of this type of investor later in this chapter.

2 The reader is referred to a book written by the authors on this area of fundamental finance: Martin J. Whitman and Fernando Diz, Distress Investing: Principles and Technique (Hoboken, NJ: John Wiley & Sons, 2009).

3 We thoroughly discuss the many substantive differences between our approach and Graham and Dodd’s in Chapter 16 of this book.

4 The relevant laws and regulations are the federal securities laws administered by the Securities and Exchange Commission: the Federal Securities Act of 1933 as amended, the Securities Exchange Act of 1934 as amended, the Investment Company Act of 1940 as amended, the Investment Advisers Act of 1940 as amended, the Trust Indenture Act of 1939, and the Securities Investors Protection Act of 1970.

5Blue sky statutes refers to state statutes governing the terms and conditions on which offerings to sell securities to the public or to buy them from the public can be made in that jurisdiction.

CHAPTER 2

A Short Introduction to the Going Concern and Resource Conversion Views of Businesses

Methods of Wealth Creation

The Pure Going Concern View

The Resource Conversion View

Summary

In this book we advocate that outside passive minority investors’ (OPMIs) common stock portfolios consist of the issues of well-capitalized companies (strong financial positions), which should be acquired at prices that represent meaningful discounts from readily ascertainable net asset values (NAVs). Although this is a necessary condition for investment success (the avoidance of investment risk), it is not a sufficient condition.