Editor's note: One of the most successful... and influential... investors alive has just produced his magnum opus, a work that Capital & Crisis editor Chris Mayer calls the "new bible of safe and cheap investing."
In the following excerpt from his most recent issue, Chris examines the work of legendary value investor Martin Whitman of the Third Avenue Value Fund. Whitman has recently published a new book detailing his investment strategies.
It's a work filled with insight into how to be a successful investor, Chris says. Much of his writing contradicts Wall Street's conventional wisdom... and it's well-worth taking the time to understand...
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The New Bible of Safe and Cheap Investing
By Chris Mayer, editor, Capital & Crisis
The secret to building great fortunes is not by taking on investment risks. "Investment" is the key adjective here. It means the risk of taking a permanent loss. (Not a temporary paper loss.) Thus, the great secret to making a fortune is to avoid taking on investment risk as much as possible.
This is how executives get rich when they get stock options. If the stock goes up, they fatten up their net worth. If the stock declines, they lose nothing. This is also how plaintiffs' lawyers get rich. The expenses of financing class-action lawsuits are minimal. The potential fee rewards upon settlement or victory are huge. There are many other examples of what are essentially free lunches.
Hence the old saying "There is no free lunch" is entirely wrong. "Rather," writes Martin Whitman, "the more appropriate comment ought to be 'Somebody has to pay for lunch — and it isn't going to be me.'"
Martin Whitman was the longtime helmsman at the celebrated Third Avenue Value Fund. He retired in 2012 and turns 89 this September. He is my favorite investor. And over the last two decades, his shareholder letters and books have had a big influence on how I think about these things. In my view, he has done more to push forward the framework of good investing than anyone since the 1930s, when Ben Graham and David Dodd published Security Analysis.
Whitman, along with co-author Fernando Diz, has just put out his magnum opus. Appropriately enough, Modern Security Analysis: Understanding Wall Street Fundamentals is the title. In a nutshell, it is a book about how to get someone else to pay for lunch. It is the new bible of safe and cheap investing as practiced by Whitman.
"Safe" means buying stocks of creditworthy companies. "Creditworthiness" is a favorite term in this book. Whitman puts his emphasis there, rather than on earnings or cash flow. Creditworthiness means a business has assets worth comfortably more than the claims against them. It means cash flows (and/or access to cash) that can meet obligations as due without sweating it. It means being able to tap the markets for cash at favorable terms. A business does not have to pass all three, but Whitman recommends that you don't get involved in anything that is not creditworthy.
"Call it overkill," he writes, "but it is also quite comfortable to be invested in the common stocks of companies whose solvency is not close to ever being in question." Besides this, super-strong finances allow one to swoop in and buy assets on the cheap during times of trouble:
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This is in tune with our philosophy of the "E" in CODE. ("E" stands for excellent financial condition.) In fact, there are many similarities between Whitman's approach and our own. This is not an accident, as I allude to above.
"Cheap" means buying stocks below "readily ascertainable net asset values" (NAV). Determining what these are is "not rocket science." Cash, marketable securities, loans, income-producing real estate and other income-producing assets are all examples of where value is relatively easy to figure out. That's the point.
A rock-solid net asset value lends conviction: "It tends to be much easier for outsiders to gain some degree of conviction if a cornerstone of their analysis is an approach that emphasizes high-quality NAV acquired at a discount price."
Anyone who lived through 2008 can appreciate the power of that insight. Earnings can change violently; NAVs almost always change gradually. NAVs provide an "anchor to windward" for the investor.
Whitman also reminds us that there are (at least) two markets for stocks. There is the market we see quoted every day. And there is the market for control, or for the whole business. Investors can exploit the differences between the two. If bank stocks trade for 1 times book value (or NAV), but strategic buyers are paying 1.5 times book value, then you buy the cheap asset. Over time, the market's tendency is to close such gaps.
Beyond this, I think one of the most important things in the book is how Whitman evaluates management teams. Most investors focus on competence in running the business. Whitman focuses not only on management as operators but also on management as investors and financiers. The quote above about the authors' most successful investments being with opportunistic management teams alludes to this.
Management teams that are opportunistic can create a lot of wealth for shareholders. They can acquire assets on the cheap. They can buy back great chunks of stock. They can sell off business units at top prices. They think creatively about the resources within a business.
I can only touch on the depth of material covered in the book. Much of it goes against mainstream and academic finance. This book is about financial realism. Whitman is a longtime practitioner. He has deep knowledge of securities markets. So he does not forget things that other investors often forget – such as the cost of transactions, the conflicts of interest and the powerful motive of tax considerations.
There is plenty of wisdom on how to be a successful investor: how big positions should be, when to sell, etc. For the most part, success has little do with what most investors spend most of their time thinking about (i.e., earnings, market outlooks, economic forecasts, interest rates and the like). Instead:
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I recommend the book, but I caution you that it is not easy reading. It is 480 pages of closely cropped text. It will feel like a textbook. But if you want to learn how to get somebody else to pay for lunch, time spent here is not wasted.
Sincerely,
Chris Mayer
Editor's note: In his monthly Capital & Crisis newsletter – published by our corporate affiliate Agora Financial – Chris consistently provides contrarian investment ideas you won't find anywhere else. To check out his impressive track record – and learn how to get a free copy of his new book, World Right Side Up: Investing Across Six Continents – click here.